Why countries trade: mercantilism and absolute advantage

A country that doesn’t trade at all is in autarky. It can consume only what it produces, so its consumption possibilities are its production possibilities (JNU 2010; CUET 2019). Open it to trade and three questions follow. Every theory in this module answers them:

1. The pattern of trade. Which goods does a country export, and which does it import?
2. The terms of trade. At what prices are they exchanged?
3. The gains from trade. Is the country better off than in autarky, and who inside it gains or loses?

Together these are the pure theory of international trade (Hyderabad 2018). It asks what does happen, a positive question, and whether it is good for welfare, a normative one (Hyderabad 2019). Money is left out on purpose: the pure theory is about real goods exchanged for real goods.

The mercantilists were merchants and officials, writing roughly from 1500 to 1750. The best-known is Thomas Mun, whose England’s Treasure by Forraign Trade appeared in 1664 (Hyderabad 2019). Their argument ran like this:

• A nation’s wealth is its stock of gold and silver, or bullion (Hyderabad 2021).
• A country without mines gets bullion by selling more abroad than it buys: an export surplus, paid for in gold.
• So the state should push exports and hold imports down, with tariffs, bans, subsidies and colonies.

Behind this sits a zero-sum view of trade. The world’s stock of gold is fixed, so one country’s surplus is another’s deficit, and one country gains only if another loses.

David Hume’s essay Of the Balance of Trade (1752) showed that the mercantilist goal defeats itself. He called the argument the price–specie flow mechanism:

1. A country runs an export surplus, and gold flows in.
2. More gold means more money, and by the quantity theory, higher prices at home.
3. Higher prices make its exports dearer abroad and imports cheaper at home.
4. Exports fall, imports rise, and the surplus disappears. Gold flows back out.

So a country can’t keep piling up gold. Even if it could, gold is not what makes people well off. Goods are.

Adam Smith started from the division of labour in The Wealth of Nations (1776). A tailor doesn’t make his own shoes, and a shoemaker doesn’t make his own clothes. Each does what he is better at and buys the rest. Smith said the same logic holds between nations.

A country has an absolute advantage in a good if it can make it with less labour than another country. Smith measured cost in labour, which is why CUET 2021 says his theory “focuses on labour”. If each country has an absolute advantage in a different good, each should make that good and trade for the other. Total output rises, and both countries can consume more.

India makes cloth with less labour and Australia makes wheat with less. Move one worker-hour in India from wheat to cloth: India loses ¼ unit of wheat and gains ½ unit of cloth. Move one hour in Australia from cloth to wheat: Australia loses ⅕ unit of cloth and gains a whole unit of wheat. Together they now have ¾ unit more wheat and 0.3 unit more cloth, from the same labour. Trade is a positive-sum game, the reverse of the mercantilist view.

Smith gave a second reason for trade, the vent for surplus. A country with idle land or labour can put them to work producing for export: trade gives an outlet, a vent, for output nobody at home would buy (Hyderabad 2016). Hla Myint revived the idea in 1958 for countries such as Burma and Thailand, whose rice exports grew in the nineteenth century without anything else falling.

The quickest way to see who gains and who loses is a single market. Before trade, the price is set where home demand meets home supply. Open the market and, for a small country, the price becomes the world price. Drag it below the autarky price and the country imports. Drag it above and it exports.

Two rules come out of the diagram:

• If the world price is below the price at home, the country imports (JNU 2017). Consumers gain, home producers lose, and the gain is bigger than the loss: Denmark’s fish consumers gain more than its fishermen lose when the price falls from $10 to $6 (JNU 2019).
• If the world price is above it, the country exports. Producers gain, consumers lose, and the producers’ gain is the larger (JNU 2017).

Either way, part of one side’s gain is just a transfer from the other side. What is left over, the green triangle, is the country’s net gain from trade. The losers are real people, though: the first to suffer from free trade are workers in import-competing industries (Hyderabad 2021). Lesson 5 shows who they are in the long run.