Finance and theories

In addition, in this economic thinking, economic activity was regarded as zero sum game in which en country’s economic gain was at the expense of another. Calculation of precious metals thus became the means for increasing wealth and well-being and the focus of the emerging Europe. In general, mercantilism are in favor of excess exports over imports or favorable trade balance. The doctrine resulted from the view surplus was equivalent to wealth or accumulation of precious metals and can be used to finance the state needs for which will reduce unemployment.

In terms of government policy, mercantilism argue that government should control the use and exchange of precious metals (bullion’s). In particular, countries attempted to prohibit the export of gold, silver and other precious metals by individuals and let the specie leave the country only out of necessity. Governments also gave exclusive rights for certain routes or areas to specific companies. Trade monopolies fostered the generation of higher profits through -2- monopoly power. Profits would contribute to a positive trade balance and wealth of rulers (E. G. He Hudson Bay and Dutch East India Trading Company). Governments controlled international trade activities with specific policies to maximize trade surplus. Exports were subsidized and high tariffs were placed on imports of consumption goods. Tariffs on imports of raw materials were kept low to support high value-added domestic manufacturing and exports. Mercantilism also pursued policies that kept wages low. Since labor was the critical factor of production, low wages mean that production costs are low thus increasing the competitiveness of domestic goods.

Since labor was crucial to the state, government stimulated a large population by various subsidies. To increase competitiveness, education is also subsidized. Chapter 3 The Classical World of David Richard and Comparative Advantage Mercantilism came under increasing attack by a group of economists political whose views eventually became known as the Classical school of economics. Hum’s price- specie-flow mechanism argument and Adam Smith’s proposition that with trade, two countries could benefit by specializing in goods in which they were more efficient were critical to the movement from protectionism to free trade.

The movement was given more impetus by the work of David Richard, The Principles of Political Economy and Taxation (1817), which stressed that potential gains from trade were not confined to absolute advantage. Often we take market-based economic system for granted without thinking how it is organized and functions. In fact, every economic system is characterized by two features: (1) specialization, in which each of us concentrates on a limited number of -3- productivities, and (2) exchange, in which most of what we desire is obtained by trading with others, rather than producing ourselves.

It is generally believed that specialization and exchange enable us to enjoy greater production, and higher living standards, than would otherwise be possible. As a The gains from specialization are mainly derived from three aspects: developing expertise, minimizing downtime and exploiting comparative advantage. (1) This has to do with human capabilities. By specializing in a narrow set of tasks, we are more likely to become experts at one or two things, instead of remaining amateurs at a lot of things.

It is easy to see that an economy of experts will produce more that an economy of amateurs. (2) When people specialize and thus spend more time doing one task, there is less unproductive “downtime” from switching activities. Adam Smith first explained these gains from specialization in his book An Inquiry into he nature and causes of the Wealth of nations, published in 1776. In fact, in explaining the efficiency of the production of a pin factory, Smith was not surprised by its sophisticated equipment, but by the division of labor among its workers.

He wrote: “In order to make a pin, one man draws out the wire, another straightens it, a third cuts its, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires three distinct operations; to put it on a separate business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and he important business of making a pin is, in this manner, divided into about 18 distinct operations, which, in some manufacturers, are all performed by distinct hands… Ten persons could make among them upwards of forty-eight thousand pins in a day…

But if they -4- had worked (wrought) separately and independently… They could (not each of them) have made twenty, perhaps not one pin in a day. ” What is true for this pin factory can be generalized to the entire economy: even when workers are identically suited to various tasks, total production will increase when workers specialize. Absolute Advantage and Comparative Advantage The proposition of absolute and comparative advantage is usually obvious in the case of individuals. Suppose in a shipwreck, there are two survivors, Maryanne and Gilligan. They were washed up on a deserted island.

Initially, they are unaware of each other, so each is forced to become self-sufficient. Maryanne finds that it takes her one hour to pick one quart of berries or catch one fish as shown in the first row of the table below. For Gilligan, it takes him 1. 5 hours to pick one quart of berries and three hours to catch one fish. The labor requirements re unit of production reflect the technologies that each individual has and imply the consumption, we can assume that each would spend part of the day catching fish and part picking berries. Suppose one day, Maryanne and Gilligan discover each other on the island.

They decide to work together to their mutual benefit. Table 1. Labor requirements for berries and fish Labor required for: -5_ 1 quart of Berries 1 Fish Maryanne 1 hour Gilligan 1. 5 hours 3 hours Absolute advantage: An individual has an absolute advantage in the production of some good when he or she can produce it using fewer resources (labor time in the example here) than another individual can. On the island, the only resource used for production is labor. From Table 1 we can see that Maryanne has absolute advantage in both berry picking and fishing over Gilligan.

She can pick on quart of berries and catch one fish using only one hour while it takes Gilligan 1. 5 hours to pick one quart of berries and three hours to catch one fish. We can also say that Maryanne is more productive in both producing both goods than Gilligan, since she can pick berries and catch fish more quickly. Two points should be noted. First, the concept of absolute advantage does not mean that n individual should have advantage in producing two goods. He may have absolute advantage in producing one good while the other party may have advantage in producing the other good.

Second, the above principle also holds true for countries, although people often lose sight of this fact. One unit of labor produces more x than is produced by one unit of labor in the other country. -6- We often hear arguments in China that to the effect that we should be producing certain good rather than importing it from abroad. Let’s use country as examples to explain the concept of absolute advantage. Suppose there are two countries in the world, the United States and China. Two gods are produced in this two country world, steel and automobiles.

The number of tons of steel and cars that one person can produce is given in Table 2 below. Table 2 one labor-year of production Products U. S. 30/yea r Automobiles China 20/yea r 40/yea r 10/year Table 2 shows that in the United States, one labor can produce 30 tons of steel in one year while in China, one labor can produce 20 tons of steel in one year. For automobiles, in the United States, one labor can produce 40 cars in one year while in China 10 cars can be produced. In this case we say that the United States has absolute advantage in producing both goods. Let’s look at another case.

We reduce the productivity of the U. S. In producing steel from 30 tons to 10 tons in one-labor year (Table 3 below). Table 3 one labor-year of production The U. S. Is relatively more productive in automobiles, and China is relatively more productive in steel. (We can measure the productivities using the concept of opportunity cost. It can be shown that the opportunity cost of producing one more ton of steel is four cars in the U. S. , but only 1/2 cars in China. So China has an advantage in steel in the sense of being the low opportunity cost producer of steel. ) This is also the case of absolute advantage, I. . , that U. S. Has an absolute advantage in automobiles production and China has an absolute advantage in steel. Problems of Using Absolute Advantage to Guide Allocation of Tasks While international trade can take place on the basis of absolute advantage (as in the third example or trade between industrial manufacturers and raw-material-rich countries) gains from trade on the basis of comparative advantage can also occur. Therefore, if e use absolute advantage as the criterion for assigning work, we may not be able to explain the whole picture of the real world trade patterns.

In the third example, China has an absolute advantage in steel production and the U. S. Has an absolute advantage in automobiles production. The determination of the trade pattern is easy. The U. S. Should specialize in producing automobiles and China in steel. For example, we move one worker in the U. S. Out of steel production and into automobile production. Similarly, we move two Chinese workers out of automobile production and into steel production. Table 4 shows the changes in output after the reallocation.

It demonstrates that simply moving the workers in each country into the industry in which the country has the advantage (its low opportunity cost industry) results in an increase in the world output of both goods. The countries may then engage in trade that leaves both better off. -8- U. S. (1 worker) China (2 workers) Total -10 +20 But in the first example, because Maryanne has an absolute advantage in both berry picking and fishing, she should produce both goods, and this however, would leave Gilligan doing nothing, which is certainly not in the pair’s best interest. Also in the second example, the U. S. As an absolute advantage in steel and automobile productions and thus it should produce both goods. This would leave China doing nothing. In fact, Adam Smith believed that in above two cases there was no basis for trade between the two parties because one party is more efficient than the other in the production of both goods. In general, absolute advantage is not a realistic guide for allocating tasks to different workers. This point was further clarified by David Richard in his book, The Principles of Political Economy and Taxation, which stressed that the potential gains from international trade was not confined to absolute advantage.

Arcadian Comparative Advantage Assumptions of the Basic Arcadian Model the Arcadian model. Several of these assumptions are very restrictive and unrealistic, but will be relaxed later and do not invalidate the basic conclusions of the analysis. 1. Each country has a fixed endowment of resources, and all units of each particular resource are identical. 2. The factors of production are completely mobile between alternative uses within a country. This assumption implies that the prices of factors of production also are the same among these alternative uses. The factors of production are completely immobile externally; that is, they do not move between countries. Therefore, factor prices may be different between countries prior to trade. 4. A labor theory of value is employed in the model. Thus, the relative value of a commodity is solely based on its labor content. From a production standpoint this implies that (a) no other inputs are used in the production process, or (b) any other inputs are measured in terms of the labor embodied in their production, or (c) the other inputs/labor ratio is the same in all industries.

In simple terms, it means that a DOD embodying two hours of labor is twice as expensive as a good as a good using only one hour. 5. The level of technology is fixed for both countries, although the technology can differ between them. 6. Unit costs of production are constant. Thus, the hours of labor per unit of production of a good do not change, regardless of the quantity produced. This means that the supply curve for any god is horizontal. 7. There is full employment. The economy is characterized by perfect competition.

No single consumer or producer is large enough to influence the market; hence, all are price takers. All -10- participants have full access to market information, there is free entry to and exit from an industry, and all prices equal the marginal cost of production. 9. There are no government-imposed obstacles to economic activity. 10. Internal and external transportation costs are zero. 11. We initially confine our analysis to a two-country, two-commodity World” to simplify the presentation of the basic Arcadian model.

This assumption will be dropped later to make the model more realistic. Comparative advantage: For an individual person to have a comparative advantage in mom good, he must be able to produce that good with a smaller opportunity cost. Similarly, a country has a comparative advantage in a good if its opportunity cost of the good in terms another good is less than in the other country. A common principle to guide the division of labor is comparative advantage. Let us start with our previous simple example of Gilligan and Maryanne.

Table 4 shows the opportunity cost of both individuals to produce berries and fish. For Maryanne, catching one fish takes one hour, time that could instead be used to pick one quart of berries. Thus, her opportunity cost of one fish is one quart of berries. Similarly, her opportunity cost of one quart of berries is one fish. For Gilligan, catching one fish takes three hours, time that he could instead use to pick two quarts of berries. The opportunity cost of one fish for Gilligan, then, is two quarts of berries, and the opportunity of one quart of berries id one-half of a fish.

Comparing the two numbers, we can see that Maryanne has a lower opportunity cost for one fish, so she has a comparative advantage in fishing. Gilligan has a lower opportunity cost for berry picking (half a fish). Therefore, while Gilligan has an absolute advantage in nothing, he has a comparative advantage in berry picking. – 1 1 Table 4 Opportunity costs 1 fish 1 /fish 1 quart of berries 2 quarts of berries Let’s see what happens as the two decide to move toward specialization according to comparative advantage.

From Table 4 we know that if Gilligan decides to catch one fewer fish, he could free up enough time to pick 1 quarts of berries. We can write down the results for Sailing’s production in this way: Gilligan: Fish 1 (Down) Berries 2(up) If Maryanne decides to catch one additional fish, she must sacrifice 1 quart of rises: Maryanne: Fish 1 (up) Berries 1 (down) Now we see what happens to total production on the island each time the pair moves toward producing according to comparative advantage.

In this case, the two will move toward specialization. Gilligan gives up fishing which will be made up by Maryanne, so Maryanne specializes in fishing. Since Maryanne will produce no berries, and all berries will be produced by Gilligan, so Gilligan would specialize in picking berries. -12- Table 1. 5 Total production before and after specialization Before specialization After specialization

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