Classical Theory of International Trade

Classical economists were oriented primarily toward growth economics, and their main concern was explaining how the “wealth of nations” was increased.

In explaining increased output, specialization and division of labour were given special attention. Adam Smith’s description of how a large number of pins could be produced when labour was specialized by detail functions as opposed to handicraft methods was widely quoted and generalized.

The extent of specialization and division of labour was dependent upon the size of the market; a larger market would encourage a greater degree of specialization and division of labour.

Questions as to the contribution of foreign trade to “wealth of nations” arose. It appeared clear that foreign trade enlarged the market and allowed further gains from specialization and division of labour. However, it was still necessary to set down the arguments clearly to show what goods would be imported and exported and to show the gains from trade.

The classical theory of international trade was formulated primarily with a view to its providing guidance on questions of national policy. Although it included considerable descriptive analysis of economic process, the selection of phenomena to be scrutinized and problems to be examined was almost always made with reference to current issues of public interest.

In the realm of foreign trade, the classical economists were mainly concerned with two questions. First, in the production of what product a country should specialize or which goods a country will export and which it will import. Second, once different countries produce different goods; what will be the ratio of exchange between goods? To the first question, the classical theory gives the following answer.

Each country will specialize in the production of those goods for the production of which it is especially suited on account of its climate, of the qualities of its soil, of its other natural resources, of the innate and acquired capacities of its people, and of the real capital which it possesses as a heritage from its past generation, such as buildings, plants and equipment’s and means of transport. Each country will concentrate upon the production of such goods, producing more of them than it requires for its own needs and exchanging the surplus with other countries against goods which it is less suited to produce or which it cannot produce at all.

The classical theory of trade is based on the labour cost theory of value. This theory states that goods are exchanged against one another according to the relative amounts of labour embodied in them. Goods which have equal prices embody equal amounts of labour. Adam Smith gives the following well-known illustration. If with the same expenditure of labour one can kill either one beaver or two deer, then one beaver will always exchange in the market against two deer. Thus exchange ratio or prices are determined solely by relative labour costs, through their influence upon supply and demand.

Broadly speaking, the labour cost theory of value holds good under following assumptions:

(i) Labour is the only factor,

(ii) All labour is of the same quality or homogeneous,

(iii) Free mobility of labour,

(iv) Every occupation is open to all,

(v) There is free competition between workers,

(vi) The marginal productivity of labour everywhere is equal to its wages.

In reality, some of these assumptions are unrealistic. In spite of the defectiveness of this theory, the classical economists used this theory to explain the exchange ratio or prices of commodities.