Classical theory of international trade

CLASSICAL THEORY OF INTERNATIONAL TRADE.

• Adam Smith and David Ricardo gave the classical theories of international trade.

• The classical theories are divided into three theories :

i) Theory of Mercantilism.

ii) Theory of Absolute Advantage.

iii) Theory of Comparative Cost Advantage.

• Assumptions made in this theory are...

a. There are two countries producing two goods.

b. The size of economies of these countries is equal

c. There is perfect mobility of factors of production within countries

d. Transportation cost is ignored

e. Before specialization, country's resources are equally divided to produce each good

• Theory of Mercantilism :

The theory of mercantilism holds that countries should encourage export and discourage import. It states that a country's wealth depends on the balance of export minus import. According to this theory, government should play an important role in the economy for encouraging export and discouraging import by using subsidies and taxes, respectively.

• Theory of Absolute Advantage :

Adam Smith gave the theory of absolute advantage stated that a country should specialize in those products, which it can produce efficiently. This theory assumes that there is only one factor of production that is labor.

In his words "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage".

Theory of Comparative Cost Advantage :

David Ricardo in his theory of comparative advantage states that trade can be beneficial for two countries if one country has absolute advantage in all the products and the other country has no absolute advantage in any of the products.

A nation, like a person, gains from the trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage."

• Theory of Comparative Cost Advantage :

This theory assumes that labor is the only factor of production in two countries, zero transport cost, and no trade barriers within the countries.