IBT Chapter 2: Classical Country-Based Theories of International Trade PDF

INTERNATIONAL BUSINESS AND TRADE NORMA DY LOPEZ-MARIANO, Ph.D., FRIEDr  Chapter 2 Classical Country-Based Theories of International Trade WWW.REX.COM.PH LESSON 2/CHAPTER 2 Introductio...

INTERNATIONAL BUSINESS AND TRADE NORMA DY LOPEZ-MARIANO, Ph.D., FRIEDr  Chapter 2 Classical Country-Based Theories of International Trade WWW.REX.COM.PH LESSON 2/CHAPTER 2 Introduction It is understandable that countries will always want to protect their own people and their own industries and businesses. There will always be pros and cons to international trade, and it will be up to the country to adopt a trade policy. How protective it should be or how liberal it should be will depend on the government of the respective countries. WWW.REX.COM.PH LESSON 2/CHAPTER 2  Lesson 2.1 International Trade Theories WWW.REX.COM.PH LESSON 2.1/CHAPTER 2  International trade theories are various theories that analyze and explain the patterns and mechanisms of international trade, how countries exchange goods and services, and help countries in deciding what should be exported and what should be imported. Trade is the concept of exchanging goods and services between two people or entities. WWW.REX.COM.PH LESSON 2.1/CHAPTER 2  International trade is the exchange of goods and services between people or entities in two different countries. International trade theories were initially country-based and were called classical theories. WWW.REX.COM.PH LESSON 2.1/CHAPTER 2  Classical economists were oriented primarily toward growth economics, and their main concern was to explain how the “wealth of nations” could be increased. In the mid-twentieth century, economists shifted from country-based to firm-based or company-based theories, which were called modern theories. WWW.REX.COM.PH LESSON 2.1/CHAPTER 2 The main points of the classical theories of international trade are the following: a. Trade is an important stimulator of economic growth. b. Trade tends to promote greater international and domestic equality. c. Trade helps countries achieve development. WWW.REX.COM.PH LESSON 2.1/CHAPTER 2 The main points of the classical theories of international trade are the following: d. In a world of free trade, international prices and costs of production determine how much a country should trade in order to maximize its national welfare. e. Participation in a world of free unlimited trade is economically far better than complete isolation to promote economic development. WWW.REX.COM.PH LESSON 2.1/CHAPTER 2  Lesson 2.2 Mercantilism WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  The “Commercial Revolution” saw the transition from local economies to national economies, from feudalism to capitalism, and from a rudimentary trade to a globally larger international trade. According to mercantilism, also known as “bullionism,” it is the goal of economy politics to ensure that the state is enriched by increasing the entry of gold and silver. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  David Hume (1711-1776) modelled the price-specie-flow mechanism to illustrate how trade imbalances can self- correct and adjust under the gold standard. According to this flow mechanism, balance of payments was a “real” phenomenon effected by changes in trade balances, and these balances were stimulated by changes in prices, which in turn resulted from gold flows between nations. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  New nation-states practiced colonization, where one country took control of another country or region. These nation-states expanded their wealth by using their colonies around the world in an effort to control more trade and amass more wealth. Protectionism – a practice where domestic industries are protected from foreign competition. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2 Adam Smith described mercantilism: Enhance economic power through building wealth; (holding of precious metals especially gold and silver) Massive and rapid unification of control (protectionism) of countries under strict economic and political policies, in sharp contrast with what was observed under feudalism resulting in economic nationalism; Countries aggressively sought to have trade surplus by selling more than they imported so as to have a surplus of precious metals. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Neo-mercantilism combines protectionism through tariffs and import barriers and domestic industry protection through subsidies and tax exemptions. Countries, at one point or another, have implemented some form of protectionist policy to guard key industries in their economy. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Capital goods – These consist of those goods which are produced by the economic system and used as inputs in the production of further goods and services. Capital refers to the money or funds used to purchase the goods used in the production process. Natural resources are found in nature, including land, trees, and mines. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Labor refers to the work performed by a person for a monetary consideration. It is the monetary consideration that forms part of the cost of production. In our modern times, the four factors of production are land, labor, capital, and entrepreneurship. Entrepreneurship – The entrepreneur is the one that combines the factors in the correct proportion and mobilizes them. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Free trade is when international trade is free from barriers, such as tariffs, quotas, or other restrictions, and can flourish on its natural growth free from government regulatory intervention. It is a system that allowed for liberalization, which paved the way for a freely initiated trade and engaged the maximum possible number of people, bringing benefits to most parties. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Laissez-faire economics is a theory that restricts government intervention in the economy. Specialization is a method of production whereby an entity focuses on the production of a limited number of goods to gain a greater degree of efficiency that would lead to the development of economies of scale. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Economies of scale occur when increasing output leads to lower long-run average costs. It means that as firms increase in size, they become more efficient. Jean-Baptiste Colbert (1619-1683) was considered a more profound influence on the development of mercantilism in France, where it was known as “Colbertism.” WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Sir William Petty (1623-1687) – an English economist, physician, scientist, and philosopher. According to him, surplus gain or surplus value leads to expanded reproduction and that expanded reproduction is conditional on capital accumulation (productive capital expansion). Expanded reproduction is a model in which a capitalist economy smoothly reproduces itself, a system founded on capital accumulation, that is, the expansion of productive capital. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Antoine de Montchretien laid great emphasis on the development of agriculture and described it as the basis of all wealth. He published a book A Tract on Political Economy where he stood the principle of self-sufficiency and asserted that it is not the abundance of gold or silver, the quantities of pearls and diamonds, which make a state rich and opulent, but the convenience of the things necessary to life. Richard Cantillon was considered by many to be the first economic theorist. He emphasized the need for importing raw materials and exporting finished products to maintain a favorable balance of trade. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Physiocrats believed that agriculture was the source of all wealth and that agricultural products should be highly priced. Giovanni Botero and Antonio Serra of Italy developed theories using the city as a unit of analysis and finding development to be the result of industrialization. They did not directly touch on mercantilism, but they emphasized that a nation can be rich through industrialization that bring results of cumulative causations originating in increasing returns. WWW.REX.COM.PH LESSON 2.2/CHAPTER 2  Lesson 2.3 Theory of Absolute Advantage WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  Absolute advantage means that a producer can produce a good or service in greater quantity for the same cost or the same quantity at a lower marginal cost. Marginal cost is the cost incurred on producing an additional unit of product. Adam Smith is recognized as the father of economics. WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  Capitalism, also called free market economy or free enterprise economy, is an economic system, where most means of production are privately owned and production is distributed through the operation of markets, which determine prices, products, and services. The physiocrats were a group of economists who believed that the wealth of nations was derived solely from agriculture. Net product is the value of the outputs minus the value of the inputs, which is a measure of income generated in a production process. WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  The theory of absolute advantage believes that countries should produce and export such products on which they have an absolute advantage and import those goods where they do not have an absolute advantage. The theory of absolute advantage, the theory of international trade, and the theory of economic development are closely interwoven. WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  Free trade promotes the international division of labor through specialization, giving certain countries an absolute advantage and paving the way for international trade that will bring about economic development. WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  Vent for surplus doctrine states that a nation can exchange its overproduction for other goods which are in demand in other countries, which will result in the fullest utilization of idle productive capacity. An additional beneficial aspect of international trade is that it transfers knowledge and technology between different nations. WWW.REX.COM.PH LESSON 2.3/CHAPTER 2  Lesson 2.4 Theory of Comparative Advantage WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  Comparative advantage means a producer can produce a good or service at a lower opportunity cost than others. Opportunity cost is what is lost or missed out on when choosing one possibility over another. WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  Adam Smith was among the first to put in writing the theory of comparative advantage, but the theory of comparative advantage was formulated by David Ricardo. For Smith, the specialization and division of labor provided the base for lowering labor costs, which ensured a comparative advantage for a country. WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  Industrial capitalism is an economic system in which trade, industry, and capital are privately controlled and operated for profit. Comparative advantage warranted complete specialization in the specific commodity with a comparative advantage in terms of labor hours used per unit of output. WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  David Ricardo started out as a successful stockbroker, making $100 million in today’s dollars. After reading Adam Smith’s The Wealth of Nations, he became an economist. Ricardo developed monetarism, the theory or practice of controlling the supply of money, as the chief method of stabilizing the economy. WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  He also developed the law of diminishing marginal returns, which states that there is a point in production where the increased output is no longer worth the additional input. WWW.REX.COM.PH LESSON 2.4/CHAPTER 2  Lesson 2.5 Heckscher-Ohlin Theory (H-O Theory) WWW.REX.COM.PH LESSON 2.5/CHAPTER 2  David Ricardo’s theory of comparative advantage posits that countries export the goods they have abundant production factors for, while they import the goods for which they have scarce production factors, which determine the comparative advantage of a country. WWW.REX.COM.PH LESSON 2.5/CHAPTER 2  Swedish economists, Eli Heckscher and his student, Bertil Ohlin, studied how a country could gain a comparative advantage by producing products that utilized factors that were in abundance in the country, and propounded the Heckscher-Ohlin theory or H-O theory, also called the factor proportions theory. WWW.REX.COM.PH LESSON 2.5/CHAPTER 2  Hecksher and Ohlin determined that the cost of any factor or resource was a function of supply and demand. Countries with cheap labor would specialize in labor- intensive industries, while countries that have large pools of capital would specialize in capital-intensive industries. WWW.REX.COM.PH LESSON 2.5/CHAPTER 2  International trade can improve economic efficiency, but that trade will also cause a redistribution of income among different factors of production; some will gain from trade, and some will lose, but the net effects are still likely to be positive. WWW.REX.COM.PH LESSON 2.5/CHAPTER 2