Classical approach to gains from international trade was an extension of the principle of division of labour developed by Adam Smith. It says that international trade enables each trading country to specialise in the production of those goods in which it has comparative cost advantage.
Consequently, reallocation of their productive resources adds to their combined output—a gain which they share amongst themselves. This enables them to raise their consumption standards and social welfare and add to their growth potential through capital accumulation.
As regards the actual division of gains between trading economies, the classical economists emphasised the role of terms of trade. A country’s gain per unit of trade depended upon the difference between the autarky and trade prices of the traded goods.
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The Size of Trading Economies:
Size of an economy refers to the size of its productive capacity and of its domestic markets. In international trade, it is reflected in its share in the total exports, and vis–vis exports of all the trading countries global share, and country-wise ranking.
The classical theory of international trade, using a two-country two- commodities model, implicitly assumes that economies are of comparable size, their industries operate under constant returns, and their consumers have similar tastes. Consequently, both can have complete specialisation.
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However, let us consider the case where other assumptions of the classical model hold, but the two economies are not of comparable size.
(a) A Small Country:
Let us suppose that the economy of our labour- abundant country 1 is so small that it is not able to influence the international terms of trade at all.
(b) A Large Country:
In contrast, if a country is so large that its international terms of trade coincide with its autarky price ratio, its traders will have no incentive to trade. And no trade or specialisation will take place.
(c) Relatively Unequal Size:
The most likely case is the one where the trading economies are of unequal size, but the share of each is large enough to push the international terms of trade between the two autarky price ratios.
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In this case, while the comparatively smaller country will specialise in the product in which it has a comparative advantage, the bigger country is not likely to reach a complete specialisation because of inadequate demand for its export good in the other country.