Classical and Neo-Classical Theories of International Trade”

UNIT 1 CLASSICAL AND NEO-CLASSICAL
Classical and Neo-
Classical Theories of

THEORIES OF INTERNATIONAL TRADE
International Trade



Structure
1.0 Objectives
1.1 Introduction
1.2 Theory of Mercantilism
1.3 Absolute Advantage Theory
1.4 Comparative Advantage Theory
1.5 Heckscher–Ohlin Theory
1.6 Stolper – Samuelson Theorem
1.7 Factor-Price Equalization Theorem
1.8 Rybczynski Theorem
1.9 Lets Sum Up
1.10 Key Words
1.11 Some useful References
1.12 Answers/Hints to Check Your Progress Exercise


1.0 OBJECTIVES
After studying this Unit, you should be able to:
 Explain the difference between Domestic and International Trade;
 describe why two nations trade with each other;
 explain Absolute Advantage Theory;
 explain Comparative Advantage Theory;
 differentiate between Absolute Advantage Theory and Comparative
Advantage Theory;
 describe Heckscher–Ohlin Theory;
 explain the Stolper – Samuelson theorem;
 explain Factor Price Equalisation theory; and
 describe Rybczynski Theorem.




Contributed by Sh. Rahul Chaudhary, Consultant IGNOU.
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,Theory of
International Trade 1.1 INTRODUCTION
In this unit, we will discuss the major theories of international trade. At the
beginning of this unit, we will try to understand what international trade is and
how it differs from domestic trade. The reasons why countries trade with each
other will also be discussed. Having understood these, the major theories of
international trade that have evolved, like absolute advantage theory, comparative
theory, and H-O theory, will be explained. Further, the theories like Stolper –
Samuelson theorem, Factor Price Equalisation theory, and Rybczynski theorem
developed by extending the H-O model will also be discussed.
Before reading the theories of international trade you should understand what is,
international trade, and why does trade take place?
In simple words, trade refers to buying and selling goods and services in
exchange for money. The sellers sell the goods and services while the buyers buy
the same. When these activities occur domestically in the country, it is referred to
as domestic trade or only trade. But, when the exchange of goods and services
takes place between buyer and seller of two different nations it is called
international trade.
Now, the question is, why do we trade at all?
The simple answer to this question is that any nation cannot produce everything it
needs. One nation may have plenty of natural resources but a scarcity of meat,
fish, etc. One country may be an efficient milk producer but have a scarcity of
wheat and rice. In this situation, nations come together and exchange goods
among them. We will discuss more about gains from trade in Unit 2.

1.2 THEORY OF MERCANTILISM
Mercantilism is an exercise that is more than 500 years old. The base of this
theory was the "commercial revolution", the transition from local economies to
national economies, from feudalism to capitalism, and from a rudimentary trade
to a larger international trade.
The theory of mercantilism postulates that countries should encourage exports
and discourage imports. The tendency to export more and import less and receive
gold (as gold was the medium of exchange) in exchange is called Mercantilism.
Mercantilism was the economic system of the major trading nations during the
16th to 18th centuries. The theory assumed that national wealth and power were
best served by increasing exports and collecting precious metals like gold in
return. The theory states that government should play a vital role in regulating the
economy to encourage exports and discourage imports by using subsidies and
taxes. According to this theory, the government should accumulate as much gold
as possible, which can only be done through exports.

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, Check Your Progress 1 Classical and Neo-
Classical Theories of
International Trade
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Explain the difference between Domestic and International Trade.
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2) Write down a short note on Mercantilism.
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1.3 ABSOLUTE ADVANTAGE THEORY
Several theories have been developed in light of the activities discussed above.
These theories have evolved for more than 200 years now. Adam Smith
propounded the basic theory of international trade in 1776. Adam Smith in his
seminal work „An inquiry into the Nature and Causes of the Wealth of the
Nation‟ for the first time, provided a theoretical explanation of why trade should
take place between two nations.
Adam Smith, in his book propounded the theory of absolute advantage, which
states that a country should specialize in those products which it can produce
efficiently, where efficiency is measured in terms of absolute labour costs. This
theory assumes that there is only one factor of production: labour.
Adam Smith wrote in „The Wealth of Nations‟, “If a foreign country can supply
us with a commodity cheaper than we can make it, better buy it of them with
some part of the produce of our industry, employed in a way in which we have
some advantage".
According to Adam Smith, trade between two nations is based on absolute cost
advantage. When one is more efficient than (or has an absolute advantage over)
another in the production of one commodity but is less efficient than (or has an
absolute disadvantage with respect to) the other nation in producing a second
commodity, then both the nations can gain by each specializing in the production
of the commodity of its absolute advantage and exchanging part of its output with
the other nation for the commodity of its absolute disadvantage. In this process,
the resources are utilized most efficiently and the output of both commodities
will rise. This increase in output of both the commodities measures the Gains
from specialization in production available to be divided between the two nations
through trade.
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