Classical Theory of International Trade

International Economics

Learning Objectives

♥ Pre-Classical Theory of International
Trade.

♥ Adam Smith’s Theory of Absolute Cost
Difference.

♥ David Ricardo’s Theory of Comparative
Cost Advantage.

♥ JS Mill’s theory of Reciprocal Demand.


3.1 Introduction
Theory of International Trade [IT] addresses
questions like
Why does or under what conditions does
IT take place?
What are the terms for the trade and
how are they determined?
Classical economists Adam Smith and David
Ricardo attributed the IT, to absolute and
comparative cost differences respectively.
Explanation for these differences was
offered by economist B Ohlin.


3.1 Introduction

Economist Bertil Ohlin also argued that
there is little difference between inter
regional trade and international trade and
there is no justification for insisting on a
separate theory for it.
He argued that
i] it is incorrect to say that labour &
capital are perfectly mobile within a country &
immobile outside. The truth is that they are to
certain extent immobile even within a country.
Hence difference in mobility in inter regional
& IT is that of a degree.


3.1 Introduction

ii] Further labour moved freely to
other countries to bring about economic
development of USA, Australia, Canada
etc in 19th and early part of 20th
century.

iii] Goods move from areas where they
are plenty to areas where they are
relatively scarce. These areas can be in a
same country [like USA, China or India] or
different countries [like Sri Lanka,
Bangladesh and Pakistan]. In first case it
is inter regional and in the next IT.


3.1 Introduction
iv] As regards existence of different
currency system through which the IT is
carried, Ohlin states that rate of exchange in
these currencies reflects their respective
purchasing power. Since they are convertible
into each other, there is a problem of
conversion in IT. This cannot be a reason for
an independent IT theory.
v] Principle of specializing in products
where it has a cost advantage is applicable to
countries as well as to regions. All trade,
whether internal or international is based on
division of labour.


3.1 Introduction

However, other economists do not agree
with Ohlin. They argue that question of
different currencies is complex, all
currencies are not equally convertible,
exchange rates vary and significantly affect
export earnings.

Further complications are created by
tariffs, import duties, export subsidies
introduced by countries to restore their
balance of payments.


3.1 Introduction

More importantly IT is between
countries with sovereign governments, they
adopt and revise their trade policies from
time to time.
All these considerations need a
separate study of IT.

It is, therefore, concluded that both on
theoretical & practical grounds,
there is a necessity of a separate theory
and study of International Trade.


3.2 Pre-Classical Theory of International
Trade.

With emergence of monetary economies that
replaced barter trade, economists argued
that the best way for the countries to
survive and grow was to hold large stock of
Gold & Silver.

With this stock, they could build armies for
protection and buy necessities, not
available locally, from other countries.


Trade.
Gold can be stocked by exploring gold
mines. But if mines were not there in the
country, {as in case of UK], country has to
export goods / services to buy gold.
This requirement, as per pre-classical
economists known as mercantilists, gives
rise to international trade.
To maximize the stock of gold , the
country should increase exports and contain
imports. Means to accomplish this were
suggested by mercantilists.


Trade.
The country that could export in excess
of its imports, thus had a favourable
balance of trade as it added to its gold
reserve. On the other hand if a country
could not cover its imports by exports ,
country’s gold stock would dwindle and it
will have an unfavorable balance of trade.
Even though acquisition of gold is no
more considered to be the sole reason for
IT, the terms ‘favorable’ & ‘unfavourable’
continue to be used in connection with
balance of trade, though in new context.


3.3 Views of Physiocracy on International Trade.

Around 1770 & 1775, French economists
brought about a new economic thinking termed
Physiocracy. They claimed that activities that
produced material surplus only can be
considered productive.
Agriculture was considered productive by
them and all other activities non productive.
International trade was non productive as both
parties exchanged equal values & there was no
surplus.
A small surplus can arise, they claimed,
only if one party was weak and accepted lesser
value in this exchange.



They were first advocates of free
trade, not to encourage trade, but because
they considered every one should have
freedom to buy whatever is available
domestically or abroad.

Mercantilists prescribed import duty to
reduce imports & preserve gold stock. They
said import duty is borne by the foreign
exporter & thus does not burden domestic
economy.



French economists demonstrated that if
commodity imported is required by consumers
they will be willing to pay its higher
price. Thus import duty cannot be passed on
to foreigners.
French economists further put forth
following argument to bring out fallacy in
pre-classical theory.
If a country following Mercantilist’s
theory, decided to maximize its gold reserve
and succeeded; it will have all the gold in
the world. Then what can it do with it?


3.4 Adam Smith’s Theory of Absolute Cost Difference
Assumptions;
1.Labour is the only factor of production.
Exchange between goods was determined by
the relative amounts of labour embodied in
them.
2.Full employment.
3.Perfect mobility of labour within a
country and zero mobility between two
countries.
4.Operation of law of constant returns.
5.Two countries and two commodities.


3.4 Adam Smith’s Theory of Absolute Cost Difference

Based on these assumptions, Smith
stated that exchange of goods will take
place, if each of two countries can
produce a commodity at an absolutely lower
labour cost of production than the other
country.

Thus England which produces cloth at
least labour input can export it to
Australia, and import wheat which it
produces at the highest labour cost.


3.5 Ricardo’s Theory of Comparative Cost Advantage

According to Smith absolute cost
difference was required for trade to take
place between two countries. Ricardo
proved that, if there is even a
comparative difference, still trade can
take place.

Thus in x man days if England produces
200 units of cloth or 200 units of wheat;
and Australia either 80 units of cloth or
160 units of wheat, there is no absolute
advantage to Australia in either products.



Still Ricardo claimed there is
comparative cost advantage & trade can
take place if England specializes in cloth
and produces 200 units and Australia
specializes in wheat and produces 160
units.

Now England can export one unit of
cloth and get anywhere up to less than two
units of wheat [ against one unit
available locally].



Australia by importing a unit of cloth
saves two units of wheat, and benefits
since it has to pay less than two units
wheat to England for it.

Thus Ricardo proved that comparative
cost advantage has allowed both countries
to trade in wheat and cloth to their
mutual benefit.



Causes for the cost difference :

a] Provision of special facilities by nature
such as
climate and soil [ that permits
plantation of rubber, jute, tea
etc].
mineral resources like petroleum,
coal, iron ore.
land fertility, availability of
abundant water.


Causes for the cost difference :
b] Provision of different human facilities
in the form of physique, mental
endowments, scientific and rational mind,
spirit of enterprise etc.
c] Legacy of the past, traditionally high
levels of intelligence and education
[provides head start in building infra
structure].
d] Uneven distribution of population that
affects availability labour for
production.


3.6 Assumptions of the Classical [Ricardian]
Theory of IT

• There are only two countries.
• There are only two commodities which these
countries can produce.
• Labor is the only factor of production
involved in production.
• All units of labor are homogenous.
• Perfect competition in labor and product
markets.


3.6 Assumptions of the Classical [Ricardian]
Theory of IT

• Full employment in both countries.
• Labor is perfectly mobile within country
and immobile between the two.
• The law of constant returns in operation
in two countries.
• No technological changes take place in the
countries.
• There are no transport costs involved.
• There are no government restrictions on
trade between the two countries.


3.7 Criticism of the Classical [Ricardian]
Theory of IT

• There are more than 150 countries involved
in active international trade, hence
restricting the theory to two countries is
unrealistic.
• Production involves material, capital &
enterprise in addition to labour, hence
restricting it exclusively to the last
factor is incorrect.
• All units of labour are not homogenous.
Some workers are more efficient than
others.


Theory of IT

• Certain degree of unemployment is always
there in each country, theory based on
full employment, therefore, is
unrealistic.
• Labour is not perfectly mobile in a
country, especially like India with its
different languages, cultures and
climates. Further workers in construction
industry cannot move to IT industry with
ease.


Theory of IT

• When output levels change there is
corresponding change in requirement of
labour inputs and usually law of
diminishing returns is experienced. Hence
theory cannot be based on constant
returns.
• In this dynamic world technological
advances are increasing productivity
effectively. The theory assumes no such
changes & renders itself unrealistic.


Theory of IT

• Movement of goods from country to country
involves significant transport costs.
These are ignored by the theory.

• International trade cannot be carried
ignoring various restrictions / provisions
that have to be prescribed by governments
to protect their economies. Hence free
trade assumed by the theory is incorrect.


Theory of IT
• The theory considers only the supply side
and ignores forces of demand on the
markets.
• Countries strategically rely on domestic
supply for essentials for its defense &
would not buy them from other countries.
• Complete specialization on the basis of
comparative cost advantage cannot work for
larger economy in trade with smaller one,
as the latter cannot absorb huge surplus
of the larger economy.


Theory of IT

• The theory fails to take into account time
element for storage and ignores interest
cost.
• It unrealistically assumes that imports of
a country will match with its exports. It
fails to consider capital cash flows.
• The theory assumes entire country
benefits from the IT. In reality only some
citizens stand to benefit & not the entire
nation.


3.8 J S Mill’s Theory of Reciprocal Demand

Ricardo’s theory established in earlier
example how England and Australia benefit
by IT when there is no absolute cost
advantage , but comparative advantage is
there.
He stated that so long as England gets
between one to two units of wheat for a
unit of cloth, it stands to benefit. But
he could not state exact units of wheat
that would be offered for export of cloth.



The mechanism for determination of rate of
exchange or terms of trade was discussed
by JS Mill. He stated that the rate
depends on England’s elasticity of demand
for England’s cloth.
‘Equilibrium would be established at that
rate of exchange between the two
commodities, at which quantities demanded
by each country would be sufficient to pay
for each other’ according to JS Mill.


He further explains
i] the possible range of barter terms
is given by the respective domestic terms
of trade as set by comparative cost
advantage in each country { between one to
two stated earlier}.
ii] within this range, the actual terms
of trade will depend on intensity of each
country’s demand for other country’s
produce.
iii] finally those terms will be stable
at which exports offered by a country will
be sufficient to pay for its imports.



Mill’s theory is based on the assumptions
similar to those used by Ricardo.

As such it is subject to same criticism as
leveled against the classical theory of
IT.

The End

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