Page 30 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes ranged the burgeoning manufacturing classes. In Britain, the opposition to the Corn Laws centred on
Manchester, the home of the textile industry. The ‘free traders’ as they were called, believed that
lower grain prices were needed so that the labouring classes in industrial areas would have access to
cheap foodstuffs. Led by Cobden, formerly a manufacturer, the free traders argued for the opening-
up of British markets to cheap grain imports from overseas. Manufacturers were also anxious that
free trade principles should be reciprocated in other countries, so that foreign markets would be
opened up to exports of cheap manufactured goods from Britain.
In Britain free trade principles eventually triumphed. In the twentieth century, with the important
exception of the period 1918 to 1939, free trade principles also came to dominate the world economy.
In this chapter we explore the economic principles which underpinned the doctrine of free trade, a
doctrine which is arguably one of the most robust of any in present-day economics. These principles
were reinterpreted in terms of modern economics by the economist Haberler in the 1930s.
Finally, a word of warning — the theory of comparative cost, on which everything in this chapter
rests, is deceptively simple! In 1996, the world-famous US economist Paul Krugman came to
Manchester, UK, to give a paper to mark the 150 years which had elapsed since the repeal of the Corn
Laws. He entitled his address ‘Ricardo’s Difficult Idea : Why Intellectuals Don’t Understand
Comparative Advantage’. In it he made clear that intelligent people who read, and even those who
write about world trade, often fail to grasp the idea of comparative advantage. The aim of this chapter
is to ensure that you fully understand the basis of the theory of trade.
Adam Smith (1723-1790) provided the basic building blocks for the construction of the classical theory
of international trade. He enunciated the theory in terms of what is called Absolute Advantage model.
Another well-known classicist, David Ricardo (1722-1823) articulated it and expanded it further into
what is called Comparative Advantage model. The models of Smith and Ricardo together constitute
what is sometimes referred to as the Supply Version of the Classical Theory of Trade, because Smith
and Ricardo paid almost exclusive attention to considerations of supply or production costs in the
determination of terms of trade and the gains from trade. The modern version of the classical theory
of trade, however, treats supply and demand with equal weight. John Stuart Mill (1806-1873), another
renowned classical economist, was the first to indicate that demand considerations must be
incorporated into the Comparative Advantage model. But Mill was not very clear or articulate. Both
Marshall and Edgeworth are credited with originating and developing the theory of offer curves,
which is a geometric technique of demonstrating the theory of reciprocal demand. All these
contributions of Smith, Ricardo, Mill, Edgeworth and Marshall put together would constitute the
modern version of the classical theory of Comparative Advantage, which is the oldest and the most
famous model of international trade.
3.1 Absolute Advantage Model of Adam Smith

Adam Smith attacked the mercantilist views on what constituted the wealth of nations, and what
contributed to ‘nation building’ or increasing the wealth and the welfare of nations. Smith was the
first economist to show that goods rather than gold (or treasure) were the true measure of the wealth
of a nation. He argued that the wealth of a nation would expand most rapidly if the government
would abandon mercantilistic controls over foreign trade. Smith also exploded the mercantilistic
myth that in international trade one country can gain only at the cost of other countries. He showed
how all countries would gain from international trade through international division of labour. In
Smith’s model of international trade, every one will be better off without making any one worse off;
this view contrasts sharply with the mercantilist philosophy that a country can be better off only by
making other countries worse off. Smith’s model of world trade is one of harmony of interests among
countries, where free trade, like honesty, would come out as the best policy for all. Let us now discuss
Smith’s model with the help of an example,

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