As mentioned above article, theoretical base of the international trade were distinguished under three categories such as classical, neoclassical and modern theories. Classical views of international trade were emphasized on three main factors. It includes gains from the trade, Structure and Direction of trade and the terms of trade. Likewise, neoclassical thoughts were also based on three factors such as Introducing social indifference curve, Introduce offer curve and Edgeworth and Concept to determine equilibrium of the international trade. Unlike the concept of constant opportunity cost in classical thoughts, neoclassical views are mainly based on increasing opportunity cost.
The classical theory of international trade was based on two basic principles of “absolute advantage” and “comparative advantage” concepts.
1. Adam Smith’s theory of Absolute Advantage
Adam Smith’s theory of absolute advantage of trade is based on value of labor theory, which indicates free trade would determine on international division of labor. According to Adam Smith, due to various reasons, including differences in technology and climate, countries of the world differ in their ability to produce various products. He explained this by considering two products and two countries and showed that trade will increase economic growth, and welfare of two countries rather than restricted. Thus, if every country produces and trade according to its own favorable production conditions, the resources, labor and capital will be utilized better and therefore, it will increase the labor productivity and material wealth [Ref.27].
According Adam Smith, the United State is more efficient than United Kingdom in producing wheat (2>1)and United Kingdom is more efficient than United States in producing textile (6>4)and thus, US get absolute advantage in producing wheat and UK get the absolute advantage in producing textile. But, Adam Smith’s theory of absolute advantage was questioned in a situation of one country has absolute advantage in both goods.
2 David Ricardo’s Comparative Advantage Theory
David Ricardo (1817) presented the theory of comparative advantage by answering to main critic of absolute advantage in a situation of if one country has advantage in both goods . Torrens and Ricardo pointed out that in such a situation, countries should specialize where they have greatest absolute advantage in both goods or least absolute advantage. This rule is known as law of comparative advantage. Thus it is not necessary for a country to possess absolute advantage in production of any product for that country to be able to participate in international trade. What is required is possess of comparative advantage in the production of one or more goods. Accordingly international trade will be occurred along the line of comparative advantage. Countries will export their comparative advantage good in exchange for their comparative disadvantage goods. According to comparative advantage theory, the equilibrium of international trade is determined by the following conditions:
(A) Terms of trade: Instead of two autarky prices for two countries, there will be one world price, which is known as terms of trade (TOT). This price will lie somewhere between the autarky prices of two countries which determine on labor productivity rate. The TOT line represents the Consumption Possibility Frontier for a country engage in international trade. It indicates the various combinations of goods (consumption bundles) a country can obtain for itself by taking advantage of international trade (see Fig 2.1).
(B) Reciprocal demand: The process of international interaction of demand and supply necessary to produce an equilibrium international price. It works in a fashion that is similar to demand and supply of other markets. If demand does not equal supply in world markets, the international price will change to bring about equality.
Fig: The Gains from Trade (country A)
Thus the Ricardian model shows how differences between countries give rise to trade and gains from trade. In this model labor it has considered that labor as the only factor of production and countries differ only in the productivity of labor. When all countries involve in international trade according their comparative advantage, it increase the world output by benefiting both countries than their autarky level. The figure shows the benefits of international trade for country A.
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