Mercantilism stretched over nearly three centuries, ending in the last quarter of the eighteenth century. It was the period when the nation-states were consolidating in Europe. For the purpose of consolidation, they required gold that could best be accumulated through trade surplus. In order to achieved trade surplus, their governments monopolized trade activities, provided subsidies and other incentives for export, and restricted imports. Since most European countries were colonial powers, they imported low cost raw material from their colonies and exported high cost manufactured goods to the colonies. They also prevented colonies from producing manufacturing. All this was done in order to generate export augmentation and import restriction lay at the root of the mercantilist theory of international trade. However, the later versions of the mercantilist doctrine explained that trade surplus was not an overlasting phenomenon. A positive trade balance led to an increase in the commodity prices relative to other countries. The increase in commodity prices caused a drop in export and, thereby, erosion in the surplus of the trade balance. Moreover, the exponents of this theory ignored the concept of production efficiency through specialization. In fact, it is production efficiency that brings in gains from trade (Heckscher, 1935).
Classical economists refuted the mercantilist notion of precious metals and specie being the source of wealth. They thought domestic production was the prime source of wealth; and thereby assumed productive efficiency to be the motivating factor behind trade. Two of the classical theories need to be mentioned here: one propounded by Adam Smith and the other propounded by David Ricardo.
Theory of Absolute Cost Advantage
Adam Smith was one of the forerunners of the classical school of thought. He propounded a theory of international trade in 1779,...