Historical overview

The barter of goods or services among different peoples is an age-old practice, probably as old as human history. International trade, however, refers specifically to an exchange between members of different nations, and accounts and explanations of such trade begin (despite fragmentary earlier discussion) only with the rise of the modern nation-state at the close of the European Middle Ages. As political thinkers and philosophers began to examine the nature and function of the nation, trade with other countries became a particular topic of their inquiry. It is, accordingly, no surprise to find one of the earliest attempts to describe the function of international trade within that highly nationalistic body of thought now known as mercantilism.

Mercantilism

Mercantilist analysis, which reached the peak of its influence upon European thought in the 16th and 17th centuries, focused directly upon the welfare of the nation. It insisted that the acquisition of wealth, particularly wealth in the form of gold, was of paramount importance for national policy. Mercantilists took the virtues of gold almost as an article of faith; consequently, they never sought to explain adequately why the pursuit of gold deserved such a high priority in their economic plans.

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Mercantilism was based on the conviction that national interests are inevitably in conflict—that one nation can increase its trade only at the expense of other nations. Thus, governments were led to impose price and wage controls, foster national industries, promote exports of finished goods and imports of raw materials, while at the same time limiting the exports of raw materials and the imports of finished goods. The state endeavoured to provide its citizens with a monopoly of the resources and trade outlets of its colonies.

The trade policy dictated by mercantilist philosophy was accordingly simple: encourage exports, discourage imports, and take the proceeds of the resulting export surplus in gold. Mercantilists’ ideas often were intellectually shallow, and indeed their trade policy may have been little more than a rationalization of the interests of a rising merchant class that wanted wider markets—hence the emphasis on expanding exports—coupled with protection against competition in the form of imported goods.

A typical illustration of the mercantilist spirit is the English Navigation Act of 1651, which reserved for the home country the right to trade with its colonies and prohibited the import of goods of non-European origin unless transported in ships flying the English flag. This law lingered until 1849. A similar policy was followed in France.

Liberalism

A strong reaction against mercantilist attitudes began to take shape toward the middle of the 18th century. In France, the economists known as Physiocrats demanded liberty of production and trade. In England, economist Adam Smith demonstrated in his book The Wealth of Nations (1776) the advantages of removing trade restrictions. Economists and businessmen voiced their opposition to excessively high and often prohibitive customs duties and urged the negotiation of trade agreements with foreign powers. This change in attitudes led to the signing of a number of agreements embodying the new liberal ideas about trade, among them the Anglo-French Treaty of 1786, which ended what had been an economic war between the two countries.

Adam Smith

Adam Smith, paste medallion by James Tassie, 1787; in the Scottish National Portrait Gallery, Edinburgh.

Courtesy of the Scottish National Portrait Gallery, Edinburgh

After Adam Smith, the basic tenets of mercantilism were no longer considered defensible. This did not, however, mean that nations abandoned all mercantilist policies. Restrictive economic policies were now justified by the claim that, up to a certain point, the government should keep foreign merchandise off the domestic market in order to shelter national production from outside competition. To this end, customs levies were introduced in increasing number, replacing outright bans on imports, which became less and less frequent.

In the middle of the 19th century, a protective customs policy effectively sheltered many national economies from outside competition. The French tariff of 1860, for example, charged extremely high rates on British products: 60 percent on pig iron; 40 to 50 percent on machinery; and 600 to 800 percent on woolen blankets. Transport costs between the two countries provided further protection.

A triumph for liberal ideas was the Anglo-French trade agreement of 1860, which provided that French protective duties were to be reduced to a maximum of 25 percent within five years, with free entry of all French products except wines into Britain. This agreement was followed by other European trade pacts.

Resurgence of protectionism

A reaction in favour of protection spread throughout the Western world in the latter part of the 19th century. Germany adopted a systematically protectionist policy and was soon followed by most other nations. Shortly after 1860, during the Civil War, the United States raised its duties sharply; the McKinley Tariff Act of 1890 was ultraprotectionist. The United Kingdom was the only country to remain faithful to the principles of free trade.

But the protectionism of the last quarter of the 19th century was mild by comparison with the mercantilist policies that had been common in the 17th century and were to be revived between the two world wars. Extensive economic liberty prevailed by 1913. Quantitative restrictions were unheard of, and customs duties were low and stable. Currencies were freely convertible into gold, which in effect was a common international money. Balance-of-payments problems were few. People who wished to settle and work in a country could go where they wished with few restrictions; they could open businesses, enter trade, or export capital freely. Equal opportunity to compete was the general rule, the sole exception being the existence of limited customs preferences between certain countries, most usually between a home country and its colonies. Trade was freer throughout the Western world in 1913 than it was in Europe in 1970.

The “new” mercantilism

World War I wrought havoc on these orderly trading conditions. By the end of the hostilities, world trade had been disrupted to a degree that made recovery very difficult. The first five years of the postwar period were marked by the dismantling of wartime controls. An economic downturn in 1920, followed by the commercial advantages that accrued to countries whose currencies had depreciated (as had Germany’s), prompted many countries to impose new trade restrictions. The resulting protectionist tide engulfed the world economy, not because policy makers consciously adhered to any specific theory but because of nationalist ideologies and the pressure of economic conditions. In an attempt to end the continual raising of customs barriers, the League of Nations organized the first World Economic Conference in May 1927. Twenty-nine states, including the main industrial countries, subscribed to an international convention that was the most minutely detailed and balanced multilateral trade agreement approved to date. It was a precursor of the arrangements made under the General Agreement on Tariffs and Trade (GATT) of 1947.

League of Nations conference

A League of Nations conference in about 1930.

Central Press/Hulton Archives/Getty Images

However, the 1927 agreement remained practically without effect. During the Great Depression of the 1930s, unemployment in major countries reached unprecedented levels and engendered an epidemic of protectionist measures. Countries attempted to shore up their balance of payments by raising their customs duties and introducing a range of import quotas or even import prohibitions, accompanied by exchange controls.

From 1933 onward, the recommendations of all the postwar economic conferences based on the fundamental postulates of economic liberalism were ignored. The planning of foreign trade came to be considered a normal function of the state. Mercantilist policies dominated the world scene until after World War II, when trade agreements and supranational organizations became the chief means of managing and promoting international trade.

The theory of international trade

Comparative-advantage analysis

The British school of classical economics began in no small measure as a reaction against the inconsistencies of mercantilist thought. Adam Smith was the 18th-century founder of this school; as mentioned above, his famous work, The Wealth of Nations (1776), is in part an antimercantilist tract. In the book, Smith emphasized the importance of specialization as a source of increased output, and he treated international trade as a particular instance of specialization: in a world where productive resources are scarce and human wants cannot be completely satisfied, each nation should specialize in the production of goods it is particularly well equipped to produce; it should export part of this production, taking in exchange other goods that it cannot so readily turn out. Smith did not expand these ideas at much length, but another classical economist, David Ricardo, developed them into the principle of comparative advantage, a principle still to be found, much as Ricardo spelled it out, in contemporary textbooks on international trade.

Simplified theory of comparative advantage

For clarity of exposition, the theory of comparative advantage is usually first outlined as though only two countries and only two commodities were involved, although the principles are by no means limited to such cases. Again for clarity, the cost of production is usually measured only in terms of labour time and effort; the cost of a unit of cloth, for example, might be given as two hours of work. The two countries will be called A and B; and the two commodities produced, wine and cloth. The labour time required to produce a unit of either commodity in either country is as follows:

cost of production (labour time)
country Acountry Bwine (1 unit)1 hour2 hourscloth (1 unit)2 hours6 hours

As compared with country A, country B is productively inefficient. Its workers need more time to turn out a unit of wine or a unit of cloth. This relative inefficiency may result from differences in climate, in worker training or skill, in the amount of available tools and equipment, or from numerous other reasons. Ricardo took it for granted that such differences do exist, and he was not concerned with their origins.

Country A is said to have an absolute advantage in the production of both wine and cloth because it is more efficient in the production of both goods. Accordingly, A’s absolute advantage seemingly invites the conclusion that country B could not possibly compete with country A, and indeed that if trade were to be opened up between them, country B would be competitively overwhelmed. Ricardo, who focused chiefly on labour costs, insisted that this conclusion is false. The critical factor is that country B’s disadvantage is less pronounced in wine production, in which its workers require only twice as much time for a single unit as do the workers in A, than it is in cloth production, in which the required time is three times as great. This means, Ricardo pointed out, that country B will have a comparative advantage in wine production. Both countries will profit, in terms of the real income they enjoy, if country B specializes in wine production, exporting part of its output to country A, and if country A specializes in cloth production, exporting part of its output to country B. Paradoxical though it may seem, it is preferable for country A to leave wine production to country B, despite the fact that A’s workers can produce wine of equal quality in half the time that B’s workers can do so.

The incentive to export and to import can be explained in price terms. In country A (before international trade), the price of cloth ought to be twice that of wine, since a unit of cloth requires twice as much labour effort. If this price ratio is not satisfied, one of the two commodities will be overpriced and the other underpriced. Labour will then move out of the underpriced occupation and into the other, until the resulting shortage of the underpriced commodity drives up its price. In country B (again, before trade), a cloth unit should cost three times as much as a wine unit, since a unit of cloth requires three times as much labour effort. Hence, a typical before-trade price relationship, matching the underlying real cost ratio in each country, might be as follows:

country Acountry BPrice of wine per unit$ 5£1Price of cloth per unit$10£3

The absolute levels of price do not matter. All that is necessary is that in each country the ratio of the two prices should match the labour–cost ratio.

As soon as the opportunity for exchange between the two countries is opened up, the difference between the wine–cloth price ratio in country A (namely, 5:10, or 1:2) and that in country B (which is 1:3) provides the opportunity of a trading profit. Cloth will begin to move from A to B, and wine from B to A. As an illustration, a trader in A, starting with an initial investment of $10, would buy a unit of cloth, sell it in B for £3, buy 3 units of B’s wine with the proceeds, and sell this in A for $15. (This example assumes, for simplicity, that costs of transporting goods are negligible or zero. The introduction of transport costs complicates the analysis somewhat, but it does not change the conclusions, unless these costs are so high as to make trade impossible.)

So long as the ratio of prices in country A differs from that in country B, the flow of goods between the two countries will steadily increase as traders become increasingly aware of the profit to be obtained by moving goods between the two countries. Prices, however, will be affected by these changing flows of goods. The wine price in country A, for example, can be expected to fall as larger and larger supplies of imported wine become available. Thus A’s wine–cloth price ratio of 1:2 will fall. For comparable reasons, B’s price ratio of 1:3 will rise. When the two ratios meet, at some intermediate level (in the example earlier, at 1:21/2), the flow of goods will stabilize.

Amplification of the theory

At a later stage in the history of comparative-advantage theory, English philosopher and political economist John Stuart Mill showed that the determination of the exact after-trade price ratio was a supply-and-demand problem. At each possible intermediate ratio (within the range of 1:2 and 1:3), country A would want to import a particular quantity of wine and export a particular quantity of cloth. At that same possible ratio, country B would also wish to import and export particular amounts of cloth and of wine. For any intermediate ratio taken at random, however, A’s export-import quantities are unlikely to match those of B. Ordinarily, there will be just one intermediate ratio at which the quantities correspond; that is the final trading ratio at which quantities exchanged will stabilize. Indeed, once they have stabilized, there is no further profit in exchanging goods. Even with such profits eliminated, however, there is no reason why A producers should want to stop selling part of their cloth in B, since the return there is as good as that obtained from domestic sales. Furthermore, any falloff in the amounts exported and imported would reintroduce profit opportunities.

In this simple example, based on labour costs, the result is complete (and unrealistic) specialization: country A’s entire labour force will move to cloth production and country B’s to wine production. More elaborate comparative-advantage models recognize production costs other than labour (that is, the costs of land and of capital). In such models, part of country A’s wine industry may survive and compete effectively against imports, as may also part of B’s cloth industry. The models can be expanded in other ways—for example, by involving more than two countries or products, by adding transport costs, or by accommodating a number of other variables such as labour conditions and product quality. The essential conclusions, however, come from the elementary model used above, so that this model, despite its simplicity, still provides a workable outline of the theory. (It should be noted that even the most elaborate comparative-advantage models continue to rely on certain simplifying assumptions without which the basic conclusions do not necessarily hold. These assumptions are discussed below.)

As noted earlier, the effect of this analysis is to correct any false first impression that low-productivity countries are at a hopeless disadvantage in trading with high-productivity ones. The impression is false, that is, if one assumes, as comparative-advantage theory does, that international trade is an exchange of goods between countries. It is pointless for country A to sell goods to country B, whatever its labour-cost advantages, if there is nothing that it can profitably take back in exchange for its sales. With one exception, there will always be at least one commodity that a low-productivity country such as B can successfully export. Country B must of course pay a price for its low productivity, as compared with A; but that price is a lower per capita domestic income and not a disadvantage in international trading. For trading purposes, absolute productivity levels are unimportant; country B will always find one or more commodities in which it enjoys a comparative advantage (that is, a commodity in the production of which its absolute disadvantage is least). The one exception is that case in which productivity ratios, and consequently pretrade price ratios, happen to match one another in two countries. This would have been the case had country B required four labour hours (instead of six) to produce a unit of cloth. In such a circumstance, there would be no incentive for either country to engage in trade, nor would there be any gain from trading. In a two-commodity example such as that employed, it might not be unusual to find matching productivity and price ratios. But as soon as one moves on to cases of three and more commodities, the statistical probability of encountering precisely equal ratios becomes very small indeed.

The major purpose of the theory of comparative advantage is to illustrate the gains from international trade. Each country benefits by specializing in those occupations in which it is relatively efficient; each should export part of that production and take, in exchange, those goods in whose production it is, for whatever reason, at a comparative disadvantage. The theory of comparative advantage thus provides a strong argument for free trade—and indeed for more of a laissez-faire attitude with respect to trade. Based on this uncomplicated example, the supporting argument is simple: specialization and free exchange among nations yield higher real income for the participants.

The fact that a country will enjoy higher real income as a consequence of the opening up of trade does not mean, of course, that every family or individual within the country will share in that benefit. Producer groups affected by import competition obviously will suffer, to at least some degree. Individuals are at risk of losing their jobs if the items they make can be produced more cheaply elsewhere. Comparative-advantage theorists concede that free trade would affect the relative income position of such groups—and perhaps even their absolute income level. But they insist that the special interests of these groups clash with the total national interest, and the most that comparative-advantage proponents are usually willing to concede is the possible need for temporary protection against import competition (i.e., to allow those who lose their jobs to international competition to find new occupations).

Nations do, of course, maintain tariffs and other barriers to imports. For discussion of the reasons for this seeming clash between actual policies and the lessons of the theory of comparative advantage, see State interference in international trade.

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