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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

    1. Nations create wealth and power

    2. National security is a top priority

      • Need strong military

      • Europe fought many wars

  2. Differences

    1. Economics – International trade

      • Everyone wins

      • Positive sum game

      • Free trade creates income and wealth for all participants

    2. 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

    1. Creates trade surplus

    2. Causes inflow of money into country, i.e. gold and silver

    3. Could cause inflation

    4. Creates wealth and power

    5. 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

    1. Nations finance industries

    2. Build roads and ports – employ workers

    3. Improve record keeping, navigation and shipping

    4. States imported skilled labor to build ships and ports

    5. Trade protection - financed by imposing taxes on imports

  5. Who benefits?

    1. King used the gold to build a strong military

      • Military is expensive

      • Wealth allows countries to buy weapons

    2. King granted licenses and permission to industry

      • Allowed monopolies to form

      • Allowed exporting firms to export products

      • Businessmen paid the king for these rights

    3. Gov. bureaucrats – expand gov.

    4. Merchants and joint stock companies

  6. Does mercantilism work?

    • Japan was devastated after WWII and became the second largest economy within one generation

    • Asian tigers and China

    • 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)

    • Countries specialize in production where they have low costs

    • Book – uses labor productivity

      • Labor productivity – amount of output each worker can produce in one hour

      • Example

Productivity U.S.   China
Soybeans 50 > 20
Laptops 6 < 10
    • 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

    • 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
  1. Law of Comparative Advantage (David Ricardo) - a country produces a product that has a relative cost advantage

    • Countries with absolute advantage still have an incentive to trade

    • 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 another

    • 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
    • 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

    • 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 resources

    • Macroeconomics

      • Country can produce two products given its resources

      • Used to illustrate trade

    • Example

      • Mexico and United States

      • Both produce tomatoes and cars

Item U.S. Mexico
Cars (max) 100 30
Tomatoes (max) 50 60
  1. Draw the PPCs

The PPCs for the United States and Mexico
Straight Line Production Possibities Curves (PPCs)
    • Comparative advantage

    • 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
    • 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

  1. Results

    • 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

    • 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 trade

      • 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

    • Developed rich countries are located in the north

    • Author – “south” has lower productivity, which translates into lower wages

    • 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

    • Exported raw materials, food, and resources

    • Resources and raw material prices are volatility in the international markets

    • Imported manufactured goods

    • Creates a trade imbalance because manufactured goods have a higher value

      • Money flows out of LDCs

      • Keeps them in poverty

    • 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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