What to produce? What to trade?
ID1123 Prof. Rubena St. Louis
The theorists
The factors
Trade in Europe during the 16th to the 18th century was controlled by the government under a system known as Mercantilism. The governments believed that wealth and power came from precious metals like gold and silver so they made laws to promote exports and restrict imports. Some laws prohibited trade with foreign countries or the use of foreign ships. There were high tariffs on goods that were allowed to be imported and incentives for local production of goods. Those governments believed that these protectionist measures would ensure a favourable balance of trade. Many wars were fought by the British, French and Dutch to protect and gain trade routes.
Claude Lorrain (1604/1605–1682)
Many people did not believe in Mercantilism and among them were Adam Smith, and David Ricardo who advocated free trade.
Adam Smith was a Scottish economist who wrote The Wealth of Nations in 1776. Smith said that countries would profit more by specialising in the production of goods for which they had an absolute advantage. He argued that countries should focus on the production of goods that were cheaper for them to produce than their competitors, and should import the goods that were expensive for them to manufacture or obtain.
David Ricardo, an English economist, showed how trade could be beneficial to countries, even those who had absolute advantage. He used an example of the production of cloth and wine in England and Portugal. Although both countries produced the same products, Ricardo showed that it would be better for England to specialise in the production of cloth and Portugal in the production of wine. The difference is due to the amount of labour/item involved in the production of each product, or its opportunity cost. Ricardo referred to this as comparative advantage. Therefore a country or a company should produce goods for which there is a lower opportunity cost.
In the twentieth century, two Swedish economists took Ricardo’s idea a little further. Eli Heckscher and Bertil Ohlin argued that comparative advantage is influenced by the amount of resources and the production technology a country has.
Remember that the major production factors are land, capital and labour. Today, entrepreneurship is also considered a factor by some economic sectors. The factors of production are those resources that are used in the production of goods and services. Land refers to all the natural resources found in a country. It includes renewable resources such as water and timber and non-renewable resources like coal or oil.
Some economists consider capital to include financial capital, money, which can be used to buy physical capital which includes buildings, vehicles, tools and equipment. Other economists consider Capital to be resources which can be used to produce goods and services. Labour, on the other hand, refers to the people, or human resources, needed to produce the good or service. Finally, entreprenurship is the ability or the skill that an individual has to combine the other factors in order to produce goods and services.
Some goods require a lot of capital and are called capital-intensive like computers or petroleum, while others require labour – labour-intensive goods, such as textiles. The Heckscher and Ohlin theory suggests that countries will export goods manufactured using resources that are abundant, and import goods manufactured with resources which are scarce. So developed countries will tend to have more capital, while developing countries will have more labour and be labour abundant. In this way, a capital abundant country will export capital-intensive products and import labour-intensive products from a developing country. These are just some of the factors that are considered when companies have to decide on what to produce, export and import.