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CHAPTER 2
EARLY TRADE THEORIES:
Mercantilism and the Transition to the Classical World of David Ricardo
Learning Objectives:
■ Explain the basic concepts and policies associated with Mercantilism.
■ Distinguish the analyses of David Hume and Adam Smith from Mercantilist views.
I. Outline
Introduction
– The Oracle in the 21st Century
Mercantilism
The Challenge to Mercantilism by Early Classical Writers
– David Hume – The Price-Specie-Flow Mechanism
– Adam Smith and the Invisible Hand
Summary
II. Special Chapter Features
In the Real World: Mercantilism Is Still Alive
III. Purpose of Chapter
The purpose of this chapter is to trace out some of the early ideas regarding the basis for
international trade and the distribution of the benefits to be gained from trade. The chapter not
IV. Teaching Tips
A. It is important to focus on the principal tenets of the Mercantilist system and then to
examine the policy positions that follow logically. This provides a good background for
evaluating various trade policy positions later in the book.
B. We feel that this is an excellent time to introduce the labor theory of value. It is a good
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opportunity to help the student begin thinking in relative terms. It is therefore important that the
relative nature of this concept is clear in the students’ minds.
V. Answers to End-of-Chapter Questions and Problems
1. Wealth was viewed as synonymous with holdings of precious metals. Nation-states
wished to become wealthy and this meant obtaining large holdings of precious metals. It is also
2. Critical pillars of Mercantilism:
a. the zero-sum nature of international trade;
b. the need for strong, powerful governments;
3. The paradox of Mercantilism is that wealthy countries would contain large numbers of
very poor people. A second paradox is that wealthy countries had to spend great amounts of
4. Critical assumptions of the price-specie-flow mechanism:
a. a link between the money supply and the price level, e.g., the quantity theory of
money;
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If the demand for traded goods were price inelastic, the movement of gold and prices
would worsen trade balances, not correct them. This would be destabilizing, not stabilizing.
5. Hume’s price-specie-flow mechanism suggested that a country could not sustain a
positive balance of trade because of the effect on money and prices. The external payments
6. The United States has an absolute advantage in the production of wheat (3 hrs./unit < 4
hrs./unit) and the United Kingdom has an absolute advantage in clothing (4 hrs./unit < 9
7. (a) In autarky the United Kingdom would produce 75 units of clothing (300 labor
hours/4 hrs.) and 50 units of wheat (200 labor hours/4 hrs.).
(b) If the United Kingdom allocates all of its labor to clothing production, it will produce
8. (a) In autarky United States wheat production will be 110 units (330 labor hrs./3 hrs.),
and cloth production will be 30 units (270 labor hours/9 hrs.).
9. A Mercantilist would view the continuing trade surplus as a very desirable outcome,
since it produces a net increase in Chinese holdings of foreign exchange (claims on foreign
country assets) which is similar to increased holdings of specie in Mercantilist times. To the
Mercantilist, the surplus represents successful Chinese policy, not a problem. Hume would
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10. With a price elasticity of demand of (-) 2.0, a 10 percent increase in price will cause the
quantity demanded in Spain to fall by 20 percent [(-2.0) (0.10)]. Because Switzerland was
initially exporting 5,000 units, the new level of exports will be 4,000 [(5,000) (1 – 0.20)]. The
new value of Swiss exports will be 440,000 francs [(4,000) (110)], which is exactly equal to its
new level of imports. The increase in Swiss prices has thus worked to remove its trade surplus
with Spain.
VI. Sample Exam Questions
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1. Explain how the price-specie-flow mechanism operates to maintain balanced trade
between countries. What are the assumptions that are critical to the mechanism’s successful
operation?
2. Why was a positive trade balance so important to Mercantilists? In Mercantilist thinking,
why did a positive trade balance not result in domestic inflation and a loss of international
competitiveness?
3. What were the critical foundations of Mercantilist thought? What trade policies resulted
from this way of thinking?
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5. (a) Why did the Mercantilists think that a situation where a country’s exports exceed its
imports is a “favorable” situation for the country? Briefly, what policies would a
Mercantilist recommend in order to generate such a “favorable” situation?
(b) What was the “price-specie-flow doctrine” and how did it undermine Mercantilist
thinking? Why would a situation where the demands for traded goods are “inelastic”
6. During the 2016 campaigns for nomination for president of the United States, the point
was frequently made that the United States was losing from trade with any given country