2.1 Classical Trade Theories

Classical trade theories form the foundation of international economics. These theories explain why countries engage in trade and how they benefit from it. From Adam Smith's absolute advantage to David Ricardo's comparative advantage, these concepts shape our understanding of global trade patterns.

The Heckscher-Ohlin model further refines trade theory by considering factor endowments. While these theories have limitations in today's complex world, they remain crucial for understanding basic trade principles and informing policy decisions. Modern theories build upon these classical foundations to address real-world complexities.

Classical Trade Theories

Concept of absolute advantage

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• Ability to produce more goods or services with same resources introduced by Adam Smith in "The Wealth of Nations" (1776)
• Production efficiency and labor productivity drive competitive edge
• Encourages specialization and mutually beneficial exchange between nations
• Countries focus on efficiently produced goods, export surplus, import others
• Example: Country A produces 10 cars or 5 computers, Country B produces 6 cars or 8 computers per day

Theory of comparative advantage

• Ability to produce goods at lower opportunity cost developed by David Ricardo (1817)
• Opportunity cost measures trade-offs between producing different goods
• Focuses on relative efficiency rather than absolute productivity
• Countries specialize in lowest opportunity cost goods, export these, import others
• Ricardian model uses two-country, two-good scenario to demonstrate trade benefits
• Leads to increased global production and consumption through specialization
• Example: US produces 100 cars or 50 planes, Japan produces 80 cars or 100 planes

Heckscher-Ohlin model for trade

• Factor proportions theory developed by Eli Heckscher and Bertil Ohlin (1933)
• Factor endowments (labor, capital, land) and intensity determine trade patterns
• Assumes two countries, two goods, two factors, identical tech, perfect competition
• Countries export goods using abundant factors, import goods using scarce factors
• Factor price equalization: trade equalizes factor prices across countries
• Stolper-Samuelson theorem links commodity prices to factor returns
• Rybczynski theorem shows impact of factor endowment changes on production
• Example: Labor-abundant India exports textiles, capital-abundant Germany exports machinery

Limitations of classical trade theories

• Assumes perfect competition, full employment, constant returns, factor mobility
• Oversimplifies real-world complexities and neglects technological differences
• Fails to account for economies of scale and product differentiation
• Disregards role of multinational corporations and government interventions
• Overlooks services trade and environmental/social considerations
• Remains useful as foundational concepts but needs integration with newer theories
• Modern theories (New Trade Theory, Gravity Model) address some limitations
• Policymakers balance free trade with other objectives (employment, environment)
• Example: Classical theories struggle to explain intra-industry trade (cars between US and Germany)