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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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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)
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˜ 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
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˜ 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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