Introduction
Economics studies the rationality of human beings. They maximize on deriving the possible benefits from a resource constraint. Economics covers a vast area. The broad meaning of economics gives rise to sub branches of economics. It may either be international economics or domestic. International economics involves both international trade and finance. It explains the patterns of transactions and relations of citizens from different countries and their consequences. International trade section of international economics studies the flows of goods and services from the international suppliers and international buyers. International finance focus on the effects of the exchange rates and capital flows over the financial markets.
Another branch of international macroeconomics and monetary economics looks into macro flows of different currencies across different nations . Final aspect of international economics is the international relations which deal with solving international conflicts, the sanctions, international agreements, as well as economic nationalism. Different theories explain international trade. International trade existed from the ancient times. Currently, exports in the international trade comprise about 15% of the national produce.
Mercantilism
Mercantilism collects heterogeneous groups’ views of people who aim regulating the countries domestic as well as its international affairs to enhance its own desires. Mercantilism prevailing in Europe between 1500 and 1800 collected similar attitudes shown by different groups of people like merchants and bankers rather than being a school of thought. The theory assumes that stock of precious metals like gold and silver reflected the nation’s wealth. During this stage, gold and silver were the accepted currency to be used in trade between nations . Thus, for a country to accumulate wealth, it had to export more and import less. Thomas Mun suggested that wealth of a nation would be increased only by foreign trade. Thus, people maximized their exports. They ensured that exports surpassed the imports. The mercantilist urged the government to ensure that exports exceeded the imports every current year to reap financial wealth. Restriction of imports by tariffs and quotas enhanced subsidization of exports. Precious metals were constant as international trade took place. All nations could not have surplus in exports. One county’s gain was the other country’s loss. This resulted in a zero sum game. The gain of one country resulted into a loss of the other country. Thus, one nation got wealthier at the expense of other nations. Mercantilist ideas influenced the history of nations shown by their effects on the government policies. Geographical explorations provided new trading opportunities and widened the international relations scope. Population increased, culture became more diverse a merchant class arose, and new precious metals discoveries followed in the new world. Religious views of profits changed, and encouraged the accumulation of the precious metals. The rise of different nations contributed the development of mercantilist idea. Thus, mercantilism is a political economy of a nations building. State power enhancement provided a pillar in the mercantilist philosophy. Colonization enhanced a cheap source of raw materials and cheap sources of labor. Hence, countries with a strong navy controlled over the navigation and trade routes of the merchants. Colonized nations also provided a market for the finished products. Bullions resulted from the importance mercantilist gave to the precious metals . The government controlled the use and exchange of these precious metals. Exports of these metals were against the country’s law and could only leave the country out of a dire need. These governments also wanted to control the trading in this theory. It gave companies trading rights over other companies. This created monopoly conditions and inhibited growth of other companies. In other instances, the government created monopsony powers to few organizations.
Absolute advantage
The absolute advantage theory means the same as absolute cost theory. Adam Smith who is the father of economics based international trade on the absolute cost advantage. In his theory, he discovered that trade between two nations would be of mutual benefit only if one nation had the ability of producing a certain commodity at an absolute advantage over the other nation . The second nation also had the ability to produce another commodity at an absolute advantage over the first nation.
A hypothetical advantage to demonstrate the production per units of labor done in USA and UK produced the following results. USA produces 10 units of wheat per unit of labor whereas UK produces 4 units of wheat per unit of labor. On the other hand, USA produced 3 units of cloths per unit of labor while UK produced 7 units of cloth per unit of labor. In this case, USA enjoys an absolute advantage over UK in producing wheat. Similarly, the UK enjoys an absolute advantage over USA in production of cloth. Adam smith proposed that, in such a case, nations must stick to production of commodities they have an absolute advantage . He advocated for specialization in areas of absolute advantage to ensure trade existed between nations. He suggested that, USA must specialize to be producing wheat. Their need for cloths should be satisfied by imports from the UK. Moreover, UK must stick and specialize in production of cloths. The demand of cloths in the USA must be met by the surplus production in the UK. By specializing in areas, one enjoys an absolute advantage it ensures that trade between the US and UK will be mutually beneficial.
Adam smith based level of specialization and division of labor on the size of the international market. Where international trade is free, it increases the level of specialization and division of labor. This increases the economic efficiency of nations in the production. The economic efficiency achieves an increase in economic welfare. In his wealth of nation’s treatise, he notes that foreign trade opens up division of labor in all the nations irrespective of their narrowness or size of the home market. Perfection of these commodities improved with the level of specialization. Different countries specializing in different products assure countries of quality product . These nations use the surplus production as a bargaining power to acquire what they never produced. Absorption of excess labor in a country enhances the growth of a nation as a society and attributes its income as the real revenue or the real wealth of the society.
Adam smith also considered international trade as the sale of surplus. International trade thus achieves productivity gain, sale of the surplus and absolute cost gain. Specialization and division of labor enhances production of large quantities of commodities. This increases the productivity per worker in a nation and thus improving the nation’s productivity. This specialization leads to productivity gain . Possessing an absolute advantage over other nations gives a country a chance to produce many commodities at lower costs. Absolute cost gain explains this absolute advantage. Moreover, the cost of production decreases with an increase in the production. Maximizing production gives nations ability to sell their surplus products to other nations and acquire what is in shortage. Nations have a guarantee of disposing the surplus. It also gives them a bargaining power to obtain what the nation lacks.
Comparative advantage
Comparative advantage theory means the comparative cost theory. An English economist named David Ricardo in his 1817 publication of “Principles of political economy and taxation” described comparative cost theory. J.S. Mill later refined this theory. This theory maintains the aspect that international trade act freely on all nations. In the long run, nations specialize in production of commodities where they enjoy a comparative advantage in the real costs of production. In addition to this, it also compares local production of a commodity and the importation costs of commodities which could be locally produced. It also compares the disadvantages real costs and ensures that all countries participating in international trade benefit mutually . This theory assumes that cost of production as only one element of labor, it assumes that exchange of goods in international trade is against each other to their respective amounts of labor used in them, assumes perfect mobility of labor within different countries and assumes homogeneity of labor. It also assumes that production follows the model of constant returns, assumes that international trade does not have any barriers in all the countries, no transport costs and full employment condition. In addition to these assumptions, the theory assumes perfect competition and assumes that the world has only two commodities and two countries. Ricardo’s use of a two-country-two-commodity model shows a county’s ability to be profitable even if either of the countries produces both commodities, and the other nation provides one of the commodities . Comparative advantage law states that, a nation must specialize to produce goods which it produces efficiently leaving the other commodity to be produced by the other nation. Both nations in the end have surplus of both commodities thus engage in trade.
Ricardo formulated a hypothetical case to analyze comparative cost advantage. He used England and Portugal. In England, a unit of cloth could be produced by a hundred units of labor and a unit of wine production required a hundred and twenty units of labor. Thus, the exchange ratio of wine and cloth became 1 wine = 1.2 cloth in England. In Portugal production of a unit of cloth required ninety units of labor and a unit production of wine required eighty units of labor. Thus, the exchange ratio in wine and cloth became 1 wine= 0.88 cloth. From this example, Portugal portrayed absolute superiority in production of both wine and cloth. However, a comparison of the ratios of costs of wine production 80/120 to that of cloth production 90/100 from both countries shows Portugal having superiority in both. Thus, Portugal will produce wine where it has a comparative advantage of production over England 80/120 is less than 90/100 and import cloth from England. England possesses a comparative advantage of producing cloths and engage with Portugal in trade to get wine. One unit of wine will fetch 1.2units in England and 0.8 unit of cloth Portugal. In the case of perfect labor mobility in both countries, Portugal gains if it gets more than 0.88 units of cloth when exchanging with a unit of wine and England gains if it pays less than 1.2 units of cloth to a unit of wine. Thus, a gain in both nations in trade lies between 0.88 and 1.2 . Reciprocal demand determines the actual exchange rate. Comparative cost theory encourages large scale specialization. It shows the best allocation of resources in the world and maximizes the world production. It helps in redistributing relative product demands thus gaining greater equality in product pricing within the trading countries. Moreover, comparative cost theory redistributes relative resource demands to have correspondence with the relative product demands and this brings equity of resource pricing among the trading countries .
Limitations
David Hume flawed mercantilist theory. According to Hume, increase in exports will lead to a surplus of the precious metals in one country. This reduces the value of these precious metals in these countries thus commodities face overvaluation to bring a balance. These nations will purchase consumption goods from other countries at higher prices. Mercantilism theory limits its explanation of international trade as a zero sum game. Ricardo and Adam Smith demonstrated trade to be a positive sum game where a single country can gain or all the trading nations gain. Adam Smith rejected mercantilist theory of the world being constant and described it as expanding in the scope of division of labor and specialization . Trade takes place in all situations unlike where the absolute theory stated that trade takes place only in the presence of an absolute cost difference.
Comparative cost theory solely depends on labor as the only cost of production which is contrary to the real world. Moreover, exchange ratio is not only determined by the cost ratio but also, by the demand and supply of the commodity. Wage differences occur in the world and thus not constant as stated in the theory. Labor is not perfectly mobile as stated by the theory and costs of commodities fluctuate with time. Forces like inflation trigger fluctuations of commodity prices. It is unreal to make an assumption of free international trade without transport costs. Ricardo oversimplifies international trade by using a two country two commodity model yet in the real world there are many countries involved . This theory never shows determination of the terms of trade.
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