STUDY UNIT 2 Mercantilists and the Classical theorists

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STUDY UNIT 2 Mercantilists and the Classical theorists

STUDY UNIT 2 Mercantilists and the Classical theorists

HOW TO USE THESE SLIDES? While working through these slides: Keep your study guide

HOW TO USE THESE SLIDES? While working through these slides: Keep your study guide and textbook open next to you and read the sections stipulated by the study guide. Ask questions if there is anything you do not understand. These slides do not cover the entire chapter, only some of the important points. Make sure you also study the other parts as stipulated by your study guide. Remember to make notes!

FOLLOW US IN YOUR TEXTBOOK… 11 th ed. page 29 - 48 10 th

FOLLOW US IN YOUR TEXTBOOK… 11 th ed. page 29 - 48 10 th ed. page 31 -53

2. 1 INTRODUCTION The section on trade theory looks at the early and classical

2. 1 INTRODUCTION The section on trade theory looks at the early and classical trade theories. Trade theories try to explain why and how countries trade. In order words, the patterns and gains from trade. We focus first on the mercantilists and the classical theorists (Adam Smith and David Ricardo).

2. 1 CONTINUE Why do countries trade? � To benefit from specialisation Since 1

2. 1 CONTINUE Why do countries trade? � To benefit from specialisation Since 1 country cannot produce all goods efficiently, it is better off producing that which it can produce efficiently and importing that which it cannot. Countries therefore trade to increase their consumption.

2. 2. MERCANTILISTS’ VIEWS ON TRADE Mercantilists were a group of writers in Europe

2. 2. MERCANTILISTS’ VIEWS ON TRADE Mercantilists were a group of writers in Europe between 1500 -1800’s. Believed that for a nation to be rich and powerful it should export more than it imported. Having a trade surplus in the form of bullion ensured riches and power. Advocated for protectionism by government in the form of tariff and other trade barriers.

2. 2 CONTINUE Trade was seen to be a zero sum game since for

2. 2 CONTINUE Trade was seen to be a zero sum game since for a nation to gain, another has to lose. Believed trade was driven by self interest. They failed to consider the impact having a surplus will have on an economy. Theory also fails to explain welfare effects of trade policy.

Watch the following video about mercantilism Click here (Internet connection required)

Watch the following video about mercantilism Click here (Internet connection required)

DO THE FOLLOWING TRUE OR FALSE QUESTIONS: 1. For the mercantilists, international trade was

DO THE FOLLOWING TRUE OR FALSE QUESTIONS: 1. For the mercantilists, international trade was a zero sum game. 2. Hume, Smith and Ricardo were followers of the mercantilist doctrine. 3. According to the mercantilists, national economic welfare can only be increased if the government encourages exports and imports.

PRACTICE ESSAY QUESTION. Mercantilists believed that two nations can gain from trade by trading

PRACTICE ESSAY QUESTION. Mercantilists believed that two nations can gain from trade by trading according to each of their absolute advantages. Is this a valid statement? Explain. [15 marks]

CASE STUDY 2 -2: MERCANTILISM IS ALIVE AND WELL IN THE 21 ST CENTURY

CASE STUDY 2 -2: MERCANTILISM IS ALIVE AND WELL IN THE 21 ST CENTURY Most countries support free trade. However, there always countries debating free trade: The USA and European Union have been disputing the trade of beef raised with hormones. The EU on the other hand prefers bananas from Africa above Central American plantations. Trade restriction are implemented to protect local jobs.

2. 3. CLASSICAL THEORISTS 2. 3. 1. True based on absolute advantage (Adam Smith)

2. 3. CLASSICAL THEORISTS 2. 3. 1. True based on absolute advantage (Adam Smith) According to Adam Smith, a nation has absolute advantage in the production of a commodity if it can produce a commodity more efficiently (less inputs) than the other nation. Having absolute advantage in the production of 1 commodity is a prerequisite for trade to occur. Countries gain from trade by specializing in producing the product of their absolute advantage.

CONTINUE Specialization (division of labour) leads to increased output of both commodities. The gains

CONTINUE Specialization (division of labour) leads to increased output of both commodities. The gains from specialization is the increased output. If one nation had absolute advantage in producing both goods, then trade will not occur. Because each country produces and exports its commodity of absolute advantage, theory suggests that there is complete specialization.

ASSUMPTIONS OF THEORY OF ABSOLUTE AND COMPARATIVE ADVANTAGE Producers and consumers are rational. There

ASSUMPTIONS OF THEORY OF ABSOLUTE AND COMPARATIVE ADVANTAGE Producers and consumers are rational. There are 2 countries and 2 commodities. Labour is the only factor of production. Each nation has a fixed endowment of resources Perfect competition exists. Free mobility of labour between the 2 goods in each country but not between nations. No barriers to trade. Constant returns to scale in production. No transport costs Technology level is fixed in both countries, though it may differ between the countries.

ABSOLUTE ADVANTAGE If they do not trade & The woman is better in The

ABSOLUTE ADVANTAGE If they do not trade & The woman is better in The man is a better A man and a woman each spend 30 min on climbing trees. In one hour swimmer and catches 20 are stranded on a catching fish and she gets 10 coconuts. The fish in an hour. The woman island. They need man only gets 6. She has an 30 min on coconuts. only catches 8. He has an absolute advantage in fish and coconuts to absolute advantage in Then they will have the getting coconuts catching fish survive. following Catching fish Climbing trees for coconuts Man 20 10 6 3 Woman 8 4 10 5

ABSOLUTE ADVANTAGE If they each specialise Let’s write in the Compare how much and

ABSOLUTE ADVANTAGE If they each specialise Let’s write in the Compare how much and trade the rest, then corner how much they have if they trade they will have more will have if they do not to the values in the coconuts and more fish! trade (just to corners! remember). Catching fish (Not trade=10) Man 10 20 (Not trade=4) Woman 4 Climbing trees for coconuts (Not trade=3) 3 (Not trade=5) 10 5

DO THE FOLLOWING QUESTIONS Output per labour day Wheat Gold South Africa Lesotho 20

DO THE FOLLOWING QUESTIONS Output per labour day Wheat Gold South Africa Lesotho 20 bushels 80 tonnes 50 bushels 20 tonnes In which commodity does Lesotho's absolute advantage lie? In which commodity does South Africa's absolute advantage lie? According to Smith, who should specialise in producing wheat? According to Smith , who should specialise in producing gold?

2. 3. CLASSICAL THEORISTS 2. 3. 3. Ricardian theory of comparative advantage (David Ricardo)

2. 3. CLASSICAL THEORISTS 2. 3. 3. Ricardian theory of comparative advantage (David Ricardo) According to Ricardo, mutually beneficial trade is possible even if one nation has absolute advantage in the production of both goods. Mutually beneficial trade will only be possible if each nation has comparative advantage in the production of one of the goods. What is important is the degree of the advantage.

CONTINUE A nation will export the commodity for which the opportunity cost is lowest

CONTINUE A nation will export the commodity for which the opportunity cost is lowest and import that for which the opportunity cost is higher. If the opportunity costs of producing the 2 goods is the same in both nations, then trade will not be possible. This implies that neither of the two nations have comparative advantage in the production of any of the commodities. This thus means that for trade to occur, the opportunity cost must be different in both nations.

COMPARATIVE ADVANTAGE Yes! Let’s look at the Now, the woman had a A year

COMPARATIVE ADVANTAGE Yes! Let’s look at the Now, the woman had a A year later the man The man has a higher Now the man has a opportunity cost. In the time it takes the man became ill and was not absolute advantage in (opportunity) cost in getting COMPARATIVE it takes the woman to catch one fish, he could fish. It will be better for the able swim any more. both fishing and one fish, she could have advantage in getting have gotten 3 coconuts man to get the coconuts Now he could only catch coconuts. Do you think gotten 1. 25 coconuts. and for the woman to fish. 2 fish in a hour. they should still trade? Man Woman Climbing trees for coconuts Catching fish 20 21 81 6 10

MORE EXAMPLES For more on absolute advantage study table 2. 1 in your textbook

MORE EXAMPLES For more on absolute advantage study table 2. 1 in your textbook For more on comparative advantages study table 2. 2 in your textbook

Still want to know more? Watch the following video about absolute and comparative advantage

Still want to know more? Watch the following video about absolute and comparative advantage Click here (Internet connection required)

DO THE FOLLOWING QUESTIONS: South Africa Ghana Gold 60 tonnes 20 tonnes Uranium 20

DO THE FOLLOWING QUESTIONS: South Africa Ghana Gold 60 tonnes 20 tonnes Uranium 20 tonnes 10 tonnes 3 G: 1 U 2 G: 1 U Domestic To. T South Africa has comparative advantage in the production of gold, while Ghana has comparative advantage in the production of Uranium. How? do the calculations of opportunity costs. International specialisation must be based on Comparative and not absolute advantage. The international terms of trade must fall between the Domestic terms of trade, that is 2 G<1 U<3 G.

DO THE FOLLOWING TRUE OR FALSE QUESTIONS: 1. If a nation can produce four

DO THE FOLLOWING TRUE OR FALSE QUESTIONS: 1. If a nation can produce four more units of X by producing one less unit of Y, then the opportunity cost of producing X is ¼ units of Y. 2. If a nation can produce one more unit of X by producing four less units of Y, then the opportunity cost of producing Y is four units of X. 3. If two nations have the same opportunity costs for two goods, then both countries have a comparative advantage in the production of both goods.

ESSAY QUESTIONS ON ABSOLUTE AND COMPARATIVE ADVANTAGE Given your knowledge of the classical theories,

ESSAY QUESTIONS ON ABSOLUTE AND COMPARATIVE ADVANTAGE Given your knowledge of the classical theories, evaluate the following statement: “According to Adam Smith, mutually beneficial trade is only possible if one nation has a comparative advantage in the production of at least one of the commodities. Note: all assumptions and criticisms must be stated. [25 marks]

END OF STUDY UNIT 2

END OF STUDY UNIT 2