THE CLASSICAL THEORY BASE INTERNATIONAL TRADE THEORIES

International trade theories are simply different theories to explain international trade. Trade is the concept of exchanging goods and services between two people or entities. International trade is then the concept of this exchange between people or entities in two different countries.

People or entities trade because they believe that they benefit from the exchange. They may need or want the goods or services. While at the surface, this many sound very simple, there is a great deal of theory, policy, and business strategy that constitutes international trade.

Classical or Country-Based Trade Theories

1. Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model)

2. The Absolute Advantage (Adam Smith model)

3. The Comparative Advantage (David Ricardo model)

1. Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model): Mercantilism is a philosophy from about 300 years ago. The base of this theory was the “commercial revolution”, the transition from local economies to national economies, from feudalism to capitalism, from a rudimentary trade to a larger international trade. Mercantilism was the economic system of the major trading nations during the 16th, 17th, and 18th century, based on the premise that national wealth and power were best served by increasing exports and collecting precious metals in return. It superseded the medieval feudal organization in Western Europe, especially in Holland, France, United Kingdom, Belgium, Portugal and Spain. The monarch controlled everything. Their policy was to export in the countries that they controlled and not to import (to have a positive Balance of Trade).

Geographical discoveries not only stimulated the international trade, but also produced an affluent flow of gold and silver, which could be used to encourage the economy based on money and prices. The state exercised much control over economic life, chiefly through corporations and trading companies. Production was carefully regulated with the object of securing goods of high quality and low cost, thus enabling the nation to hold its place in foreign markets.

The theory states that the world only contained a fixed amount of wealth and that to increase a country wealth; one country had to take some wealth from another, either through having a higher import/export ratio. So, this tendency, to export more and import less and to receive in exchange gold (the deficit is paid in gold) is called MERCANTILISM. The theory was criticized by the newly appeared class. More money was associated with less products and inflation. The standard of living is weaker. Mercantilist ideas did not decline until the coming of the Industrial Revolution and of laissez-faire (Jones, 1961).

2. The Absolute Advantage (Adam Smith model)

In the second half of the XVIII century, mercantilist policies became an obstacle for the economic progress. Adam Smith (father of liberalism and economical science) brought the argument in his book “The Wealth of Nations”, published in 1776, that the mercantilist policies favorised producers and disadvantaged the interests of consumers.

Adam Smith’s theory starts with the idea that export is profitable if you can import goods that could satisfy better the necessities of consumers instead of producing them on the internal market. The essence of Adam Smith theory is that the rule that leads the exchanges from any market, internal or external, is to determine the value of goods by measuring the labour incorporated in them.

In order to demonstrate its theory, Adam Smith analyzed for the beginning country A, using one factor of production, the productivity of labour, evaluated in the necessary of hours needed to produce a unit of measure of the products X and Y. He used a unifactorial system of economy.

Symbolizing H-hours, L-labour, the unitary necessary of labour for product X is HLX and for Y HLY. Because all the economies have limited resources, there are limits in the level of production, and if a country wants to produce much of one product it has to give up producing another goods, existing in this case renounce of trade. Renounces can be illustrated by a graphic.

3. The Comparative Advantage (David Ricardo model)

David Ricardo theory demonstrates that countries can gain from trade even if one of them is less productive then another to all goods that it produce. The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries  (McKenzie, 1956).

Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity.