Exam 2: Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

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A zero-sum game is a situation in which one person's gain is exactly balanced by another person's loss. In other words, the total amount of wealth or resources in the game remains constant, and any gain by one party must come at the expense of another party. This concept was central to Mercantilist thinking, which was an economic theory prevalent in Europe during the 16th to 18th centuries. Mercantilists believed that a nation's wealth and power were determined by its accumulation of precious metals, such as gold and silver. They viewed international trade as a zero-sum game, where one country could only gain at the expense of another. Therefore, the goal of Mercantilist policies was to export more than import in order to accumulate precious metals and gain an advantage over other nations.

Adam Smith's idea of absolute advantage altered the nature of the "game" by introducing the concept of mutual benefit in international trade. Smith argued that countries should specialize in producing goods in which they have an absolute advantage, meaning they can produce those goods more efficiently than other countries. By specializing and trading with other countries, both parties can benefit from the exchange, leading to an overall increase in wealth and resources. This idea challenged the zero-sum mentality of Mercantilism and laid the foundation for the theory of comparative advantage, which suggests that even if one country is less efficient in producing all goods, there are still gains from trade for both parties. Smith's ideas shifted the focus from hoarding precious metals to promoting free trade and cooperation, ultimately changing the nature of international economic relations.

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The price-specie-flow mechanism operates to maintain balanced trade between countries by adjusting the flow of gold and silver between them. The mechanism is based on the idea that if a country runs a trade surplus, it will export more goods and receive payment in the form of gold and silver. This increase in the country's supply of precious metals will lead to an increase in the money supply, causing prices to rise. As prices rise, the country's goods become more expensive for foreign buyers, leading to a decrease in exports and a return to balanced trade.

Similarly, if a country runs a trade deficit, it will import more goods and pay for them with gold and silver, leading to a decrease in the country's supply of precious metals and a decrease in the money supply. This will cause prices to fall, making the country's goods more attractive to foreign buyers and leading to an increase in exports, again returning the trade to balance.

The assumptions critical to the mechanism's successful operation include the assumption that prices are flexible and will adjust to changes in the money supply, the assumption that there is free movement of gold and silver between countries, and the assumption that there are no barriers to trade that would prevent the adjustment of trade imbalances. Additionally, the mechanism assumes that there is a fixed exchange rate system in place, as changes in exchange rates would affect the flow of gold and silver and disrupt the mechanism's operation. Overall, the price-specie-flow mechanism relies on the automatic adjustment of prices and the flow of precious metals to maintain balanced trade between countries.