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CLASSICAL THEORY
Answers three aspects:
Gains from trade ± benefits and their division among
trading countries
Structure of trade ± actual imports, exports and allocation
of resources and flow of trade
Terms of trade ± rate at which imports and exports are
traded
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In his Wealth of the Nations (1776), Adam Smith
promoted free trade by comparing nations to
households,
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Adam Smith attacked the mercantilist assumption
that trade is a zero-sum game (one country gains at
the cost of other one losing)
Countries differ in their ability to produce goods
efficiently, and that a country has an !
!!! in the production of a product when it is
more efficient than any other country in producing it
Countries should specialize in the production of
goods for which they have an absolute advantage and
then trade these goods for the goods produced by
other countries
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A country has an ! !!! over another in
the production of good X when an equal quantity of
resources can produce more X in the first country than
in the second = higher productivity!
!!!!
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#! $% ! &' !
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!
Country A will produce and export wine.
Country B will produce and export cloth.
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!!!)!!, each country divides its own
production capacity between wine and cloth
Total wine production 35 bareels (25+10)
Total cloth production 25 bales(10+15)
m !!!)!!,
With 2 units of labour, A produces 50 barrels of wine
and B 30 bales of cloth
Excess 15 bareels of wine and 5 bales of cloth with
same 2 units of labour put forth by each country
!!*!(!( !!
* !
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Clear-cut absolute cost advantage or one country has an
absolute advantage in the production of all goods as a
special and not a general case for trade as unexplained
by Adam Smith
A country to specialize in the production of those goods
that it produces most efficiently and to buy the goods
that it produces less efficiently from other countries
" ( !!!) ! ( ! (
! (!( ! ! !!" * !+++
! ! (! ! !!! ! ! !
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A difference in comparative costs of production ± the necessary
condition for international exchange to occur ± does, in fact,
reflect a difference in the techniques of production, the capital
and labor inputs, and productivity.
The theory also aims at showing that trade is beneficial to all
participating countries: win/win!
Positive-sum game of international trade!
The gains from specialisation and trade depend on the pattern
of * !!!, not absolute advantage.
With no trade, each countryµs consumption is limited by its
ability to produce.
With free trade, each country specializes in producing only one
good.. Each country can reach its desirable levels of
consumption by trading.
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ðixed endowment of resources, and homogenous factors
ðactors of production completely mobile between alternative
uses within a country with identical factor prices and
completely immobile externally with factor prices be
different across countries prior to trade
A labor theory of value is employed for the model.
Costs of production are constant horizontal supply curve.
ðull employment and perfect competition.
No government-imposed obstacles to economic activity
(free trade)
Internal and external transportation costs zero.
Two-country and two-commodity trade
Static model
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In the example England has absolute
disadvantage in both productions while
Portugal has absolute advantage
However comparative disadvantage of England
is less in case of cloth and comparative
advantage is more for Portugal in case of
production of wine
Accordingly England will produce and export
cloth and Portugal would produce and export
wine
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International rate of exchange would be
1W=1C
Therefore gains of England would be 1.20 -
1.00 = 0.20 while that of Portugal would be
1.00 - 0.89 = 0.11
The total gains from trade with comparative
costs advantage would be 0.31(0.20+0.11)
The two selling limits would be 0.89 and 1.20
for both. The terms of trade will fall within
these limits
( ! !! * !+
Lacks positive approach and explains normative approach(welfare
model and not trade model)
Unrealistic assumptions
No explanation for differences in labour productivity between
countries
Restrictive in nature
Does not suit a trade between big and small sized countries
Lack of universal application on defense and self-sufficiency
basis
One sided and ignores demand factor
Leaves protection policies out of application of theory
Not applicable to undeveloped economies
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