advantages. 2
The mercantilists were also attacked for their static view of the world economy.
To the mercantilists, the worlds wealth was fixed. This view meant that one nations
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 Smiths The Wealth of Nations. According to
Smith (17231790), the worlds 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). Smiths dynamic view of trade suggested that both trading partners
could simultaneously enjoy higher levels of production and consumption with trade.
Smiths 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
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Kingdom, the U.S. production cost will be lower.
Smiths 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 hours time, while workers in the United Kingdom can produce 15 bottles of wine or 10 yards of cloth in an hours 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
