For the first time, an attempt to determine the meaning of foreign trade, to formulate its goals, was made in the economic doctrine of mercantilists.
Mercantilists (Thomas Moon, Charles Davenant, Jean Baptiste Colbert, William Petty) held a statistical view of the world, which, from their point of view, had only a limited amount of wealth. Therefore, the wealth of one country could increase only at the expense of the impoverishment of another.
Associating a country’s wealth with the amount of gold and silver it possessed, the mercantilist school of foreign trade believed that in order to strengthen its national position, the state should:
maintain a positive balance of payments – to export goods more than to import, which allows to increase the inflow of gold, production and employment; regulate foreign trade to increase exports and reduce imports through tariffs, quotas and other instruments; prohibit the export of raw materials and allow duty-free import of raw materials that are not mined in the country, which will allow accumulating gold and keeping export prices for finished products low; prohibit all trade of colonies with countries other than the mother country, as well as the production of finished goods. Thus, the colonies turned exclusively into suppliers of raw materials to the metropolises.
The school of mercantilism existed for 150 years and contributed to the theory of international trade:
for the first time, the importance of foreign trade for the economic growth of countries was emphasized; the balance of payments was first described; gave impetus to the development of the classical school in the world economy.
Part of the terminology of the mercantilism times has survived to the present time. The term trade surplus, for example, is still used to indicate that a country exports more than it imports. A passive trade balance indicates a trade deficit. Many of these terms are used essentially incorrectly: for example, the word “active” (favorable) implies a benefit, and “passive” (unfavorable) indicates a loss. In reality, it is not necessary to have a trade surplus, nor is a deficit necessarily unprofitable.
If a country has a surplus, or trade surplus, it receives goods and services for a certain amount of time at a lower cost than it exports outside its borders. During the period of mercantilism, the difference was compensated by the transfer of gold, and today it is compensated by providing a loan to a country with a deficit balance of payments. If the loan is not repaid in full, the so-called trade surplus may actually prove unprofitable for a country with a surplus.
The term neomercantilism is used to refer to countries that are clearly trying to have a trade surplus in order to achieve some social or political goal.
For example, a country may try to achieve full employment by producing beyond what demand dictates in the country and exporting the surplus abroad. Or the country may be trying to maintain political influence in some region by supplying more goods there than it receives from there.
The views of the mercantilists were limited, consisting in the fact that they saw the enrichment of one nation only at the expense of the impoverishment of another, and achieved this with the help of protectionist policies. A different view was held by representatives of the classical school.
A. Smith’s theory of absolute advantage
In his 1776 book A Study on the Nature and Causes of the Wealth of Nations, Adam Smith criticized the mercantilist position that a country’s wealth depended on the ownership of gold. He stated that the real wealth of a country consists of goods and services available to its citizens. Smith developed the theory of absolute advantage, which states that some countries can produce goods more efficiently than others. On the basis of this theory, he posed the question: “Why should the citizens of the country buy domestic goods, if they can buy the same abroad at a lower price?”
In accordance with the views of A. Smith:
governments should not interfere in foreign trade, maintain open markets and free trade; nations, like private individuals, must specialize in the production of those goods in the production of which they have an advantage and trade them in exchange for goods in the production of which other nations have an advantage; foreign trade stimulates the development of labor productivity by expanding the market beyond national borders; export is a positive factor for the country’s economy, as it ensures the sale of surplus products that cannot be sold in the domestic market; export subsidies are a tax on the population: they lead to higher domestic prices and should be abolished.
Smith argued that if trade was not restricted, each country would specialize in producing products that had a competitive advantage. Each country’s resources will flow into profitable industries, as the country will not be able to compete in unprofitable industries. Through specialization, countries will be able to increase productivity, because:
the workforce can become more skilled when performing the same tasks; employees will not waste time switching from one type of product to another; long periods of homogeneous production will provide incentives for more efficient working methods.
A country will be able to use the surplus of its specialized products to acquire more imports than it might otherwise produce. But in the production of what products should the country specialize? Smith believed that the market would help to answer this question, but at the same time it is necessary to take into account the advantages of the country, both natural and acquired.
A country may have a natural advantage in production due to climatic conditions or due to the possession of certain natural resources. For example, the efficiency of tea, rubber and coconut production in Sri Lanka is mainly due to favourable climatic conditions.
But in today’s global trade, most of the turnover consists of finished goods and services, not minerals and agricultural products. The location of production of these goods is mainly related to the acquired advantage, usually due to the production technology.
The advantage in production technology is the ability to produce diverse or complex products. Denmark, for example, exports silverware not because there are rich Danish mines, but because Danish companies produce high-quality products. The advantage in production technology is also related to the ability to produce homogeneous products more efficiently. For example, Japan exports steel, although it must import iron and coal, the two main components of steel production. The main reason for Japan’s success is that its steel mills use highly efficient technological processes that save labor and raw materials.
Thus, a country has an absolute advantage if there is such a product that it can produce more per unit of cost than other countries. In order for trade to be mutually beneficial, the price of any commodity in the foreign market must be higher than the domestic equilibrium price for the same product in the exporting country, and lower than in the importing country.
The theory of absolute advantage does not take into account the differences between countries in their production specialization; however, some recent studies, based on the size of a country, helped to explain how much and what type of products would be involved in trade. Consider the main provisions of the theory of the size of the country.
Variety of resources. The country size theory argues that because countries with a larger area have diverse climatic conditions and natural resources, they are generally closer to self-sufficiency than small countries.
Transportation costs. Although the theory of absolute advantage neglects transport costs, the latter have different effects on large and small countries. Usually, the greater the distance, the higher the transportation costs, the average distances for trade are greater in large countries, and the normal maximum distance of transportation of a particular product is 100 miles, because when this distance is exceeded, prices rise too much. Most U.S. manufacturing and market facilities are more than 100 miles from the Canadian or Mexican border. And in the Netherlands, almost all production and market facilities are located within 100 miles of the border. Thus, it is transport costs that are most likely to force small countries to participate in trade.
Economies of scale. While the area occupied is the most obvious way to measure countries, the latter can also be compared by the size of their economies. Advanced economies with high per capita incomes are likely to produce goods that use technologies that require longer output, because these countries are developing industries to serve vast domestic markets. These same industries strive to achieve competitiveness in export markets.