International Trade T heory

The theory of trade has a central place in economic analysis, and underpins the doctrine of free trade. Free trade doctrines have a long and fascinating history in Europe. In 1846 Britain repealed the Corn Laws, an historic event which marked the start of the era of free international trade, and lasted until the great depression of the 1870s. The Corn Laws were the duties on imports of grain, which had been in force in England since the middle of the fifteenth century. Other European countries had similar taxes: France, Sweden, Bavaria, Belgium and Holland.

The reasoning behind the Corn Laws was as follows. Grain, chiefly wheat, is a staple foodstuff, especially important in the diets of labouring people. But its price varies greatly from year to year, depending on the size and quality of harvests. Duties on imports were levied on a sliding scale in order to stabilise the price of wheat. When the domestic price was high because of a poor harvest, duties were lowered to permit imports. When the domestic price was low because of a bumper harvest, import duties were raised.

In the decades leading up to the repeal of the Corn Laws in Britain, the system had fallen into disrepute. In fact the sliding scale of duties was tending to increase rather than reduce fluctuations in the price of wheat. When the domestic price was high, traders tended to withhold supply to raise the price even further. They anticipated that import duties would soon be lowered, which was in fact what tended to happen. Then, when duties fell, traders began to import large quantities of grain. As supply rapidly increased, and prices fell dramatically, import duties were quickly increased. The net effect was to amplify market fluctuations through speculation, making a vulnerable market even more unstable, much to the detriment of consumers.

The Corn Laws had another important effect, They benefited agricultural interests at the expense of the newly emerging manufacturing sectors. High prices of grain, maintained through restricting foreign supply, increased the value of land. Landowners, understandably, came to constitute an important pressure group for the maintenance of the Corn Laws. Against these landed interests were ranged the burgeoning manufacturing classes, In Britain, the opposition to the Corn Laws centered on Manchester, the home of the textile industry. The ‘free traders’ as they were called, believed that lower grain prices were needed so that the laboring classes in industrial areas would have access to cheap foodstuffs. Led by Cobden, formerly a manufacturer, the free traders argued for the opening-up of British markets to cheap grain imports from overseas. Manufacturers were also anxious that free trade principles should be reciprocated in other countries, so that foreign markets would be opened up to exports of cheap manufactured goods from Britain.

In Britain free trade principles eventually triumphed. In the twentieth century, with the important exception of the period 1918 to 1939, free trade principles also came to dominate the world economy. In this chapter we explore the economic principles which underpinned the doctrine of free trade, a doctrine which is arguably one of the most robust of any in present-day economics. Chapter 2 starts with the mercantilist thinking which pre-dates the free trade era, and passes on to the writings of Adam Smith and David Ricardo, which formed the basis of the case for free trade. These principles were reinterpreted in terms of modern economics by the economist Haberler in the 1930s.

Finally, a word of warning – the theory of comparative cost, on which everything in this chapter rests, is deceptively simple! In 1996, the world-famous US economist Paul Krugman came to Manchester, UK, to give a paper to mark the 150 years which had elapsed since the repeal of the Corn Laws. He entitled his address ‘Ricardo’s Difficult Idea: Why Intellectuals Don’t

Understand Comparative Advantage’. In it he made clear that intelligent people who read, and even those who write about world trade, often fail to grasp the idea of comparative advantage. The aim of this chapter is to ensure that you fully understand the basis of the theory of trade.

MercantilismMercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it imports, and advocates government intervention to achieve a surplus in the balance of trade.

The theory of trade is part of the classical liberal tradition of economic thought. Classical liberalism is often described as the dominant ideology of capitalism. It is associated with the industrialization of western Europe, a process which began in the eighteenth century.

Mercantilist economic thinking is a philosophy of political economy which predates classical liberalism. It was characteristic of economic thinking in Europe from the late Middle Ages through to the sixteenth and seventeenth centuries.

It is important to understand the key principles of mercantilist thinking because mercantilist ideas lingered on in international trade even when they had been largely discredited in the domestic context. Indeed in the present day there are many who are still wedded to certain mercantilist philosophies in the international economy, and advocate protectionist policies in foreign trade which might be described as ‘neo-mercantilist’.

Mercantilism emerged in the period between 1300 and 1500, when Europe was experiencing an acute shortage of gold and silver bullion for use as money in domestic and international transactions. Trade was growing but the money supply could not keep pace. To ensure sufficient bullion to meet the rising needs of commerce, monarchs and their advisers discouraged imports of goods since an excess of imports over exports required the export of gold and silver in payment for imports. By the same token, every effort was made to expand exports of goods, since exports would draw in gold and silver from abroad and thus increase the domestic money supply. Of course, since one country’s exports are another’s imports, this could never be a recipe for harmonious international relations. All countries could not enjoy the benefits of an export surplus!

The following features characterized the mercantilist system as it operated in Europe in the centuries before the rise of free trade:

● Extensive regulation of imports and exports: - Some imports were prohibited altogether, others were subjected to high rates of import duty. In England the Navigation Acts of 1651 and 1660 aimed to exclude foreign ships from both the import and export trade. Even the export of raw materials (wool, for example) from England was restricted in order to keep input prices low and make the finished product (textiles) more portable in foreign and domestic markets.

● Trade monopolies flourished: - Governments permitted one merchant (or a group of merchants acting together) to operate in domestic and foreign markets. This meant that merchants could sell goods abroad at high prices because there was no price competition among sellers. Merchant capitalists with monopoly power dominated economic activity in England, France, Spain, Belgium and Holland.

● Smuggling flourished: - Large profits could be made by traders who were willing to import or export prohibited goods. Smuggling of bullion was especially profitable. Most of the gold from South America flowed into Spain. In Spain there were severe penalties, including death, for merchants who smuggled bullion out of the country. Nevertheless, large quantities of Spanish bullion found its way into all parts of Europe.

● There were significant incentives for European governments to establish colonial empires: - England France, Holland, Belgium and Spain established colonies. Colonies enabled the metropolitan country to control trade with weaker countries. The colony was required to provide cheap raw materials for manufacturers in the metropolitan countries. Colonies also provided protected markets for a home country’s manufactured exports.

Even when bullion supplies to Europe increased in the mid-sixteenth century, mercantilist restrictions on international commerce remained. This was because it was widely believed that tariffs were a good way to increase domestic output and employment, and to boost the power of the monarch. Tariffs were a source of revenue for the monarch out of which the army and navy and huge state bureaucracies could be paid. Import restrictions, it was believed, stimulated domestic manufacturing by keeping out foreign competition. To this end there were in place wide-ranging domestic regulations covering manufacturing and commerce. These included patents and monopoly rights, statutes governing apprenticeships, maximum wage rates, and tax exemptions and subsidies.

From the seventeenth century onwards, however, it became increasingly apparent that regulations imposed on domestic output and employment, together with restrictions on international trade, were hindering the growth of enterprise. Writers such as Dudley North (1641– 91) argued that economies would flourish only if restrictive laws which bestowed special privileges were removed. By the beginning of the eighteenth century there was a growing recognition, even in mercantilist writings, that emerging capitalists needed greater freedom to pursue profitable investment opportunities. This was the background against which Adam Smith published the path-breaking book Wealth of Nations in 1776, which is universally regarded as the foundation of modern market economics, and is the starting point for the theory of trade.

Adam Smith and absolute advantageAdam Smith was a Scotsman, born in 1723, the son of a Scottish Judge Advocate and Comptroller of Customs. He became Professor of Logic and then of Moral Philosophy in the University of Glasgow. This was followed by travels in France as tutor to the young Duke of Buccleuch, with a final appointment as Commissioner of Customs, which he held until his death in 1790. Smith can justifiably be described as the first professional economist! He was also thoroughly familiar with the practicalities of trade and tariffs.

Political and economic liberalism found their expression in Smith's argument that the wealth of nations depends upon the goods and services available to their citizens, rather than the gold reserves held by the sovereign. Smith’s Wealth of Nations has been described as the most profound intellectual achievement of classical liberalism. It was conceived as an attack on what Smith called the mercantile system. The basis of Smith’s criticism of mercantilism was that it enabled certain merchants to enrich themselves by exploiting monopoly concessions and other ‘extraordinary privileges’. Such activities did not enhance the material welfare of society. Regulations governing foreign trade, such as bounties, monopoly grants and restrictive trade

treaties, though they secured a large stock of bullion and a favourable trade balance, and may have enriched individual merchants, nevertheless conferred no general benefit on society.

What Smith favoured was a free market where hard work, enterprise and thrift would be rewarded. In a free market, without state regulation, monopoly and privilege, entrepreneurs would be encouraged to behave in a competitive, efficient and dynamic manner. In pursuing profit they would contribute to the wider social interest. They would be rewarded for doing things which added to the welfare of society, not for actions that diminished the common good.

Specialisation and exchange

Adam Smith observed that the division of labour increases productivity and wealth. As individuals specialise in certain activities they become more skilful and productive. But they also become more dependent on others for their needs. Specialisation therefore implies exchange ‘where every man may purchase whatever part of the produce of other men’s talents he has occasion for’ (Wealth of Nations, book I).

Specialisation and exchange enable everyone in a community to benefit by purchasing goods and services from low-cost sources of supply. According to Smith, it is ‘the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy’. Smith then extended this principle into the sphere of foreign trade: ‘What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.’ If commodities could be purchased abroad more cheaply than they could be made at home, then it would be foolish to put obstacles in the way of importing them. Such restrictions could only impede the welfare of the whole community.

The critique of mercantilism, together with the case for free trade, is contained in books III and IV of Wealth of Nations. There are three powerful ideas to bear in mind in the remainder of this chapter:

● A nation’s wealth depends on its productive capacity. Gold and silver do not of themselves constitute a nation’s wealth. Gold and silver can be ‘wasted’ on luxury spending. But if gold and silver are used to purchase materials and tools, or to employ labour, then productive capacity and future wealth is assured.

● Laissez-faire is the best way to increase productive capacity. Governments should remove restrictions and privileges to permit the expansion of industry and trade. Once freed from the burden of the state, social harmony and economic progress will triumph.

● International trade is mutually beneficial for all trading countries. Every country benefits from being able to export those commodities which it produces efficiently, and being able to import those commodities which it produces inefficiently. There are no ‘losers’ from free trade. All are ‘gainers’.

Absolute advantageSmith claimed that a country should specialize in, and export, commodities in which it had an absolute advantage. An absolute advantage existed when the country could produce a commodity with less labor per unit produced than could its trading partner. By the same

reasoning, it should import commodities in which it had an absolute disadvantage. An absolute disadvantage existed when the country could produce a commodity only with more labour per unit produced than could its trading partner.

Table 2.1 is a simple arithmetical example of the principle of absolute advantage. The countries in the table (the UK and the US) are not, of course, the ones familiar to Smith, nor are the commodities (wheat and cloth) the ones which feature in Wealth of Nations, but the principle is universal. To simplify matters, we will continue to use these two commodities and countries whenever we are dealing with the two-country, two-commodity case.

Table 2.1 indicates that the UK has an absolute advantage in cloth production and an absolute disadvantage in wheat production. The US has an absolute advantage in wheat production and an absolute disadvantage in cloth production. Both countries will gain if the UK specialises in cloth and exports it to the US, and the US specialises in wheat and exports it to the UK. In modern terminology, trade is a positive sum game. Everyone gains from specialisation and exchange, though we may note from the outset that there is no reason to expect everyone to gain equally.

Labour theory of value

The classical economists, of whom Smith was the first, regarded labour as the sole source of value. The quantity of labour embodied in a commodity measured the value of that commodity.

The arithmetical example of Table 2.1 is consistent with a labour theory of value, since the exchange value of each commodity is determined by the amount of labour time (output per unit of labour) necessary for its production. The classical writers operated with a labour theory of value. Although Smith had not developed a price related demand schedule in the modern sense he did recognize that demand for acommodity needed to be taken into consideration. Producers in search of profit would not continue to produce commodities for which there was no market. Market demand was needed if producers were to cover their costs of production. Market demand would determine what commodities were to be exchanged and the relative amounts to be produced.

Table 2.1 Absolute advantage (arithmetical example)

Output per unit of labour UK US

Production of wheat 5 20

Production of cloth 10 6

Smith also recognised that workers differed in aptitudes and abilities. The lazy and unskilled worker would be less productive than the industrious and skilled worker. It is labour, as opposed to the labourer, which is the measuring rod in the labour theory of value. Labour, Smith claimed, was alone ‘the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared’

Comparative advantage

1817, David Ricardo - Even if one country has an absolute advantage in producing two products over another country, trading with that other country will still yield more output for both countries than if the more efficient producer did everything for themselves.

David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods. Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home.

The country with the absolute advantage in producing both products would still produce both products, but less of the one they would trade for, allowing them to essentially allocate more resources to producing the product that they’re comparatively most efficient at producing

Assumes many things: o Only 2 countries and 2 goodso No transportation costso No price differences for resources in both countrieso Resources can move freely from producing one product to producing another

producto Constant returns to scaleo Fixed stock of resourceso Free trade does not affect production efficiencyo No effects of trade on income distribution within a country

There are some descriptions of potential outcomes of relaxing some of these assumptions, but I’ll leave this as a thought exercise for you, the reader

Specialization and trade should occur according to the relative opportunity costs of production in each country, measured in terms of the alternative production given up to produce a tradable good.

 Example:

resources required per unit output:Tea Wheat

Sri Lanka 10 10

United States 5 4

The opportunity cost of tea in Sri Lanka is 1 unit wheat;  the opportunity cost of tea in the US is 1.25 units wheat.  Sri Lanka has comparative advantage in tea production, despite its absolute disadvantage in the production of each commodity.