Classical economists developed their theory of international trade both as a sequel, and as an alternative, to the so-called mercantilist philosophy.
The theoretical framework built by the classical economists was able to provide answers to several basic questions relating to international trade. In essence, most of these answers are valid even now.
One of the basic claims of classical theory is that international trade in goods is a substitute for international mobility of factors of production. And it substantiates this claim with the help of a few simplifying assumptions.
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It assumes that the economies of trading countries are competitive and, consequently, the commodity prices correspond to their production costs (inclusive of normal profit), and that there is unrestricted trade between them.
It also recognizes the fact that there are inter-country differences in production costs (and, therefore, prices) of commodities.
Ordinarily, these cost and price differences should provide producers with an opportunity of increasing their profit incomes by shifting their production centres from high-cost to low-cost areas. But, they are not able to do so because of two reasons:
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Production centres can be shifted to new locations only when factors of production are also shifted there.
The classical theory, however, assumes a total absence of international mobility of factors of production.
During those days, there was widespread recognition of benefits of unrestricted international trade and the classical economists advocated it very forcefully. Consequently, they concluded that international trade was a substitute for international movement of factors of production.
Assumptions of the Theory:
Classical theory of international trade is in the nature of a model with a large number of simplifying assumptions for explaining the basic causes and direction of international trade. They include the following:
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The theory takes a simple case in which there are only
(a) Two countries and two goods, and
(b) Each country can produce both goods.
Each country has a given endowment of productive resources and they are fully employed.
All units of a productive factor are homogeneous, that is, they have same productive efficiency.
Production technologies are given and no change takes place in them on account of international trade.
The production of both goods is subject to constant returns to scale so that a change in the production volume of a commodity does not cause a change in its average or marginal cost.
Both trading economies are able to shift their productive resources, within their borders, from one good (employment) to the other. There are no legal, institutional or other hurdles in doing so.
In other words, there is perfect mobility of factors of production within a country. However, it is also assumed that there is a complete absence of mobility of factors of production from one country to the other.
Both economies are competitive so that pre-trade (or autarky) prices of products correspond to their respective costs of production.
Classical theory assumes applicability of labour theory of value. It means that, before trade, relative prices of goods are in the ratio of their labour cost of production, where labour itself is measured in standard labour units. This assumption can be interpreted in two ways:
(a) It can be assumed that labour is the only factor of production and is also homogeneous (that is, all units of labour are equally efficient). If so, then in each country, ratios of pre-trade prices (also called autarky prices) of goods would be equal to the corresponding ratios of their labour cost of production.
(b) Alternatively, it may be assumed that techniques of production are such that the ratios of autarky prices of goods are equal to the corresponding ratios of the labour component of their respective production costs.
Classical theory assumes that currencies of the trading countries are on gold standard T his ensures that exchange rate remains fixed and price differences do not occur due to changes in it.
In addition, the existence of gold standard rules out any balance of payments difficulties, because a country can import goods only when it can pay for them in the form of either exports or gold outflow. There are no credit sales.
The classical theory also assumes the validity of quantity theory of money with the result that any imbalance in trade automatically causes corresponding variations in money supply and prices. And this, in turn, restores equality between exports and imports.
Consumers in the two countries have similar tastes and preferences. This assumption implies that produce of one country can be sold in the other without any shift in demand schedules. It also allows the possibility of a country meeting its entire demand for a commodity only through imports.