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Unit 3 : Free Trade Theory — Absolute Advantage, Comparative Advantage and Opportunity Cost

somewhere between the two internal cost ratios (of the two countries) both the countries will share Notes
the gains from trade—equally or unequally, depending upon whether the terms of trade are exactly
between the two cost ratios or whether they are closer to one country’s internal cost ratio or the other
country’s internal cost ratio. If the terms of trade are closer to the internal cost ratios in Malaysia then
Malaysia will gain less than the other country would; if reverse is the case, then India will gain less
than Malaysia.
It is important to emphasize that production gains alone are not sufficient to determine the profitability
of international trade from the standpoint of an individual member country’s welfare gain from
trade. Production gain is the GNP gain or income gain. How the consumption gains are determined
is crucial in determining whether the economic well-being (or the standard of living measured by
consumption gains) of a member country has gone up as a result of international trade. International
terms of trade therefore, play a very important part in determining the welfare gains from trade.
International trade would be beneficial and profitable for a country only if it results in consumption
gains. Production gains alone do not constitute profitable trade from the standpoint of the country
concerned.
Today we often hear the complaint that the international terms of trade are very unfavourable to the
LDCs. We hear that the advanced industrial countries have been receiving extremely favourable
terms of trade. If this is true then the benefits of international trade are going largely to the rich
countries. This would aggravate global income inequalities which are already astounding. In that
case, international trade would be acting as a source of international inequalities of income and
wealth as between the developed and the developing countries of the world. International trade, no
doubt, creates prosperity through interdependence. But interdependence can work both ways. We
must be careful with the nature of interdependence. The producer and the consumer and
interdependent, but the bargaining strength of the consumer may be weaker. What the consumer
would be seeking, in fact, is interdependence with equity. That characterizes what most developing
countries are concerned about—a greater balance, a greater equity in the relationship between
developing and the developed countries. Interdependence, resulting from international division of
labour, does not necessarily guarantee equitable trade relationship among nations. Free trade, based
on perfect competition, may result in unequal distribution of gains among the countries of the world,
even while it increases world prosperity in a spectacular way. It is, therefore, very important that the
international terms of trade are just and equitable because profitability of trade is dependent on
terms of trade.
Adam Smith’s model of classical theory, like the rest of the classical theory of trade, emphasizes the
gains from trade i.e., the classical theory is a contribution to welfare economics; and welfare economics
is value-loaded. In the classical trade theory the welfare of every individual unequivocally improves
with trade; and in the limiting case where a large country trades with a small country, the small
country gains more from trade than does the large country. Because, the equilibrium terms of trade
nearly coincide with the large country’s pre-trade internal price ratio. Thus, in the classical theory the
introduction of trade does not make anybody or any country worse off. Not only do all countries gain
from trade, in the classical model, but also small countries gain more than the large countries do,
emphasizing greater equity inherent in international trade mechanism. Unlike mercantilists who
saw conflict of interest among nations, the classical economists saw only harmony of interest among
trading nations. This is what led them to pronounce that some trade is better than no trade, more
trade is better than less trade, and free trade is better than restricted trade. The economists of the
Third World today, however, are not so sure about this. In their view, international trade discriminates
against countries which are poor, less developed or too small to exercise any bargaining power with
those who are rich, powerful and well developed. This is part of the current theme of what is called
as “North-South Dialogue” or the “New International Economic Order”.
Getting back to the classical trade theory, it is enough to note that Adam Smith showed convincingly
how countries could gain from trade. In his model, to recapitulate, one country has an absolute
advantage over the other country in one line of production, and the other country has an absolute
advantage over the first country in the other line of production. The two countries’ internal pre-trade
cost ratios are not the same. International terms of trade would lie somewhere between the opportunity

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