Thus shows that mercantilist policies could provide at best only short-term economic

advantages. 2

The mercantilists were also attacked for their static view of the world economy.

To the mercantilists, the world’s wealth was fixed. This view meant that one nation’s

gains from trade came at the expense of its trading partners; not all nations could

simultaneously enjoy the benefits of international trade. This view was challenged

with the publication in 1776 of Adam Smith’s The Wealth of Nations. According to

Smith (1723–1790), the world’s wealth is not a fixed quantity. International trade

permits nations to take advantage of specialization and the division of labor, which

increase the general level of productivity within a country and thus increase world

output (wealth). Smith’s dynamic view of trade suggested that both trading partners

could simultaneously enjoy higher levels of production and consumption with trade.

Smith’s trade theory is further explained in the next section.

Although the foundations of mercantilism have been refuted, mercantilism is

alive today. However, it now emphasizes employment rather than holdings of gold

and silver. Neo-mercantilists contend that exports are beneficial because they result

in jobs for domestic workers, while imports are bad because they take jobs away

from domestic workers and transfer them to foreign workers. Thus, trade is consid-

ered a zero-sum activity in which one country must lose for the other to win. There

is no acknowledgment that trade can provide benefits to all countries, including

mutual benefits in employment as prosperity increases throughout the world.

4 Adam Smith's the absolute advantage theory

Adam Smith, a classical economist, was a leading advocate of free trade (open markets) on the grounds that it promoted the international division of labor. With free trade, nations could concentrate their production on the goods that they could make the most cheaply, with all the consequent benefits from this division of labor.

Accepting the idea that cost differences govern the international movement of goods, Smith sought to explain why costs differ among nations. Smith maintained that productivities of factor inputs represent the major determinant of production cost. Such productivities are based on natural and acquired advantages. The former include factors relating to climate, soil, and mineral wealth, whereas the latter include special skills and techniques. Given a natural or acquired advantage in the production of a good, Smith

reasoned that a nation would produce that good at a lower cost and thus become more competitive than its trading partner. Smith viewed the determination of competitiveness from the supply side of the market. Smith founded his concept of cost on the labor theory of value that assumes that, within each nation, labor is the only factor of production and is homogenesus (of one quality) and the cost or price of a good

depends exclusively on the amount of labor required to produce it. For example, if the United States uses less labor to manufacture a yard of cloth than the United

Kingdom, the U.S. production cost will be lower.

Smith’s trading principle was the principle of absolute advantage: in a two-nation, two-product world, international specialization and trade will be beneficial when one nation has an absolute cost advantage (that is, uses less labor to produce a unit of output) in one good and the other nation has an absolute cost advantage in the other good. For the world to benefit from specialization, each nation must have a good that it is absolutely more efficient in producing than its trading partner. A nation will import those goods in which it has an absolute cost disadvantage; it will export those goods in which it has an absolute cost advantage. An arithmetic example helps illustrate the principle of absolute advantage. Referring to Table 2.1, suppose workers in the United States can produce 5 bottles of wine or 20 yards of cloth in an hour’s time, while workers in the United Kingdom can produce 15 bottles of wine or 10 yards of cloth in an hour’s time. Clearly, the United States has an absolute advantage in cloth production; its cloth workers’ productivity (output per worker hour) is higher than that of the United Kingdom, which leads to lower costs (less labor required to produce a yard of cloth). In like manner, the United Kingdom has an absolute advantage in wine production.

According to Smith, each nation benefits by specializing in the production of the

good that it produces at a lower cost than the other nation, while importing the good

that it produces at a higher cost. Because the world uses its resources more efficiently

as the result of specializing, an increase in world output occurs that is distributed to

the two nations through trade. All nations can benefit from trade, according to Smith.

The writings of Smith established the case for free trade, which is still influential

today. According to Smith, free trade would increase competition in the home mar-

ket and reduce the market power of domestic companies by lessening their ability to

take advantage of consumers by charging high prices and providing poor service.

Also, the country would benefit by exporting goods that are dear on the world mar-

ket for imports of goods that are cheap on the world market. Smith maintained that

the wealth of a nation depends on this division of labor, which is limited by the extent

of the market. Smaller and more isolated economies cannot support the degree of

specialization that is needed to significantly increase productivity and reduce cost,

and thus tend to be relatively poor. Free trade allows countries, especially smaller

countries, to more fully take advantage of the division of labor, thus attaining higher

levels of productivity and real income.

5. David Ricardo s theory of the comparative advantage Production possi schedules