International Trade and Economics of Less: The Mercantilist Fallacy

The Mercantilist Fallacy International trade benefits all trading nations. What one nation gains in the aggregate from trade, its trading partner does not lose in the aggregate. This point was misunderstood by 17thand 18th-century advocates of mercantilism, a doctrine arguing that a nation could increase its power by encouraging exports and discouraging imports. In the eighteenth and early nineteenth centuries, gold and silver were used as international currency to settle foreign debts. A nation that consistently ran a balance of trade surplus would require nations with a balance of trade deficit to settle the difference in gold and silver. Nations that exported more than they imported thereby accumulated gold and silver in their national treasuries. The mercantilists mistakenly believed that nations losing gold and silver were made worse off by international trade. What they didn't understand was that the well-being of a nation is not measured by gold, silver, or other commodities in storage. Instead its well-being depended on the goods and services its citizens could purchase with their available incomes. International trade allowed citizens in the aggregate to expand their consumption possibilities beyond their domestic production possibilities. The gains from trade consisted of the expansion of consumption possibilities. A nation that pursued policies that encouraged exports but discouraged imports in order to gain gold, silver, or other commodities to hold in storage simply gained purchasing power for the future. If imports were artificially restricted by such policies, citizens of the nation were deprived of the opportunity to enjoy imported goods that other nations could produce at lower opportunity costs. Terms of Trade The incentive to trade comes because consumers in each nation can gain by obtaining certain goods at lower opportunity cost than would be possible if the goods were domestically produced. To gain from trade, nation B would have to obtain wheat from nation A at any price below its opportunity cost of 2 tons of bananas for each ton of wheat. Similarly, to have incentive to trade, nation A would have to obtain bananas from nation B of wheat per ton of bananas at a price that is below its opportunity cost of 1 ton In actuality, prices for goods are determined by world demand and supply. The real terms of trade represent the actual market exchange rate of one good for another in international trade. For there to be incentive to trade, the terms of trade must be below the opportunity cost per unit of producing the good domestically. The greater the difference between the real terms of trade and a nation's opportunity cost of producing each extra unit of the good it wants to import, the more the nation gains from trade. For example, nation B is better off if the terms of trade allow it to get each ton of wheat for 1½ tons of bananas than it is if it has to give up 2 tons of bananas for each ton of wheat. However, nation A is better off if the terms of trade are 2 tons instead of 1½ tons of bananas for a ton of wheat. When the terms of trade for a pair of goods improve for one nation specializing in one good, they deteriorate for its trading partner specializing in the other good. However, as long as the terms of trade are less than each nation's opportunity cost of producing each unit, both nations still gain from engaging in specialization and trade. Suppose the agreed-upon real-world terms of trade are 1½ tons of bananas for each ton of wheat. It's now easy to show how each nation's consumption possibilities are extended beyond its production possibilities by international exchange of goods at the agreed-upon terms of trade. Note that the agreed-upon terms of trade can also be expressed as ⅔ ton of wheat for each ton of bananas. For example, if nation A specializes in wheat production and trades its entire annual output of 20 tons of bananas, it will receive 30 tons of bananas in exchange by trading with nation B and other nations specializing in banana production. By specializing, nation A can consume a maximum of 30 tons of bananas instead of 20 tons. A consumption possibilities curve shows combinations of two goods a nation can consume given its resources, technology, and international trade. The graph in Box 8 shows nation A's consumption possibilities curve when it can trade wheat at the rate of ⅔ ton for each ton of bananas. The consumption possibilities curve is not as steep as the production possibilities curve, because less wheat must be given up in trade than in production for each ton of bananas. In fact, as shown in Box 9, at the agreed-• upon terms of trade, the cost of a ton of bananas to residents of nation A has fallen from 1 ton of wheat to ⅔ ton of wheat. Naturally, bananas are a better buy as imports than they are when domestically produced. The shaded area in the graph in Box 8 represents the combinations of wheat and bananas that can be enjoyed when trade is possible at the agreed-upon terms but that could not be enjoyed if the nation tried to be self-sufficient in bananas and wheat. International trade therefore allows consumers the option to consume more of both wheat and bananas. Similarly, the graph in Box 10 shows how trade shifts the consumption possibilities for nation B above its production possibilities. For example, by specializing in banana production and selling the entire annual crop of 10 tons on international markets, nation B can consume 6⅔ tons of wheat per year. If instead it allocates all of its own resources to wheat production, the most it can consume is 5 tons of wheat. The slope of the consumption possibilities curve for nation B is steeper than the slope of its production possibilities curve, because, as shown in Box 11, the possibility of international trade decreases the opportunity cost of enjoying a ton of wheat from 2 tons of bananas to only 1½ tons of bananas. The shaded area in the graph in Box 10 shows the combinations of wheat and bananas that are attainable through trade that would not be attainable if nation B attempted to be self-sufficient in wheat and bananas. As a result of international trade, citizens in each nation now have the opportunity to enjoy points on their new consumption possibilities curves rather than their production possibilities curves. Because, given their resource availability, citizens in all trading nations will enjoy more goods and services when they trade. This is not to say that all citizens will be better off. As you'll see shortly, international trade can make some people worse off, especially in the short run.