1. International Trade Theory
The theory of trade has a central place in economic analysis, and underpins the doctrine of free
trade. Free trade doctrines have a long and fascinating history in Europe. In 1846 Britain
repealed the Corn Laws, an historic event which marked the start of the era of free international
trade, and lasted until the great depression of the 1870s. The Corn Laws were the duties on
imports of grain, which had been in force in England since the middle of the fifteenth century.
Other European countries had similar taxes: France, Sweden, Bavaria, Belgium and Holland.
The reasoning behind the Corn Laws was as follows. Grain, chiefly wheat, is a staple foodstuff,
especially important in the diets of labouring people. But its price varies greatly from year to
year, depending on the size and quality of harvests. Duties on imports were levied on a sliding
scale in order to stabilise the price of wheat. When the domestic price was high because of a
poor harvest, duties were lowered to permit imports. When the domestic price was low because
of a bumper harvest, import duties were raised.
In the decades leading up to the repeal of the Corn Laws in Britain, the system had fallen into
disrepute. In fact the sliding scale of duties was tending to increase rather than reduce
fluctuations in the price of wheat. When the domestic price was high, traders tended to withhold
supply to raise the price even further. They anticipated that import duties would soon be
lowered, which was in fact what tended to happen. Then, when duties fell, traders began to
import large quantities of grain. As supply rapidly increased, and prices fell dramatically, import
duties were quickly increased. The net effect was to amplify market fluctuations through
speculation, making a vulnerable market even more unstable, much to the detriment of
consumers.
The Corn Laws had another important effect, They benefited agricultural interests at the
expense of the newly emerging manufacturing sectors. High prices of grain, maintained through
restricting foreign supply, increased the value of land. Landowners, understandably, came to
constitute an important pressure group for the maintenance of the Corn Laws. Against these
landed interests were ranged the burgeoning manufacturing classes, In Britain, the opposition to
the Corn Laws centered 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 laboring 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.
Chapter 2 starts with the mercantilist thinking which pre-dates the free trade era, and passes on
to the writings of Adam Smith and David Ricardo, which formed the basis of the case for free
trade. 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

2. 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.
Mercantilism
Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to
export more than it imports, and advocates government intervention to achieve a surplus in the
balance of trade.
The theory of trade is part of the classical liberal tradition of economic thought. Classical
liberalism is often described as the dominant ideology of capitalism. It is associated with the
industrialization of western Europe, a process which began in the eighteenth century.
Mercantilist economic thinking is a philosophy of political economy which predates classical
liberalism. It was characteristic of economic thinking in Europe from the late Middle Ages
through to the sixteenth and seventeenth centuries.
It is important to understand the key principles of mercantilist thinking because mercantilist
ideas lingered on in international trade even when they had been largely discredited in the
domestic context. Indeed in the present day there are many who are still wedded to certain
mercantilist philosophies in the international economy, and advocate protectionist policies in
foreign trade which might be described as ‘neo-mercantilist’.
Mercantilism emerged in the period between 1300 and 1500, when Europe was experiencing an
acute shortage of gold and silver bullion for use as money in domestic and international
transactions. Trade was growing but the money supply could not keep pace. To ensure
sufficient bullion to meet the rising needs of commerce, monarchs and their advisers
discouraged imports of goods since an excess of imports over exports required the export of
gold and silver in payment for imports. By the same token, every effort was made to expand
exports of goods, since exports would draw in gold and silver from abroad and thus increase the
domestic money supply. Of course, since one country’s exports are another’s imports, this could
never be a recipe for harmonious international relations. All countries could not enjoy the
benefits of an export surplus!
The following features characterized the mercantilist system as it operated in Europe in the
centuries before the rise of free trade:
● Extensive regulation of imports and exports: - Some imports were prohibited altogether,
others were subjected to high rates of import duty. In England the Navigation Acts of 1651 and
1660 aimed to exclude foreign ships from both the import and export trade. Even the export of
raw materials (wool, for example) from England was restricted in order to keep input prices low
and make the finished product (textiles) more portable in foreign and domestic markets.
● Trade monopolies flourished: - Governments permitted one merchant (or a group of
merchants acting together) to operate in domestic and foreign markets. This meant that
merchants could sell goods abroad at high prices because there was no price competition
among sellers. Merchant capitalists with monopoly power dominated economic activity in
England, France, Spain, Belgium and Holland.

3. ● Smuggling flourished: - Large profits could be made by traders who were willing to import or
export prohibited goods. Smuggling of bullion was especially profitable. Most of the gold from
South America flowed into Spain. In Spain there were severe penalties, including death, for
merchants who smuggled bullion out of the country. Nevertheless, large quantities of Spanish
bullion found its way into all parts of Europe.
● There were significant incentives for European governments to establish colonial empires: England France, Holland, Belgium and Spain established colonies. Colonies enabled the
metropolitan country to control trade with weaker countries. The colony was required to provide
cheap raw materials for manufacturers in the metropolitan countries. Colonies also provided
protected markets for a home country’s manufactured exports.
Even when bullion supplies to Europe increased in the mid-sixteenth century, mercantilist
restrictions on international commerce remained. This was because it was widely believed that
tariffs were a good way to increase domestic output and employment, and to boost the power of
the monarch. Tariffs were a source of revenue for the monarch out of which the army and navy
and huge state bureaucracies could be paid. Import restrictions, it was believed, stimulated
domestic manufacturing by keeping out foreign competition. To this end there were in place
wide-ranging domestic regulations covering manufacturing and commerce. These included
patents and monopoly rights, statutes governing apprenticeships, maximum wage rates, and tax
exemptions and subsidies.
From the seventeenth century onwards, however, it became increasingly apparent that
regulations imposed on domestic output and employment, together with restrictions on
international trade, were hindering the growth of enterprise. Writers such as Dudley North
(1641– 91) argued that economies would flourish only if restrictive laws which bestowed special
privileges were removed. By the beginning of the eighteenth century there was a growing
recognition, even in mercantilist writings, that emerging capitalists needed greater freedom to
pursue profitable investment opportunities. This was the background against which Adam Smith
published the path-breaking book Wealth of Nations in 1776, which is universally regarded as
the foundation of modern market economics, and is the starting point for the theory of trade.
Adam Smith and absolute advantage
Adam Smith was a Scotsman, born in 1723, the son of a Scottish Judge Advocate and
Comptroller of Customs. He became Professor of Logic and then of Moral Philosophy in the
University of Glasgow. This was followed by travels in France as tutor to the young Duke of
Buccleuch, with a final appointment as Commissioner of Customs, which he held until his death
in 1790. Smith can justifiably be described as the first professional economist! He was also
thoroughly familiar with the practicalities of trade and tariffs.
Political and economic liberalism found their expression in Smith's argument that the wealth of
nations depends upon the goods and services available to their citizens, rather than the gold
reserves held by the sovereign. Smith’s Wealth of Nations has been described as the most
profound intellectual achievement of classical liberalism. It was conceived as an attack on what
Smith called the mercantile system. The basis of Smith’s criticism of mercantilism was that it
enabled certain merchants to enrich themselves by exploiting monopoly concessions and other
‘extraordinary privileges’. Such activities did not enhance the material welfare of society.
Regulations governing foreign trade, such as bounties, monopoly grants and restrictive trade

4. treaties, though they secured a large stock of bullion and a favourable trade balance, and may
have enriched individual merchants, nevertheless conferred no general benefit on society.
What Smith favoured was a free market where hard work, enterprise and thrift would be
rewarded. In a free market, without state regulation, monopoly and privilege, entrepreneurs
would be encouraged to behave in a competitive, efficient and dynamic manner. In pursuing
profit they would contribute to the wider social interest. They would be rewarded for doing things
which added to the welfare of society, not for actions that diminished the common good.
Specialisation and exchange
Adam Smith observed that the division of labour increases productivity and wealth. As
individuals specialise in certain activities they become more skilful and productive. But they also
become more dependent on others for their needs. Specialisation therefore implies exchange
‘where every man may purchase whatever part of the produce of other men’s talents he has
occasion for’ (Wealth of Nations, book I).
Specialisation and exchange enable everyone in a community to benefit by purchasing goods
and services from low-cost sources of supply. According to Smith, it is ‘the maxim of every
prudent master of a family, never to attempt to make at home what it will cost him more to make
than to buy’. Smith then extended this principle into the sphere of foreign trade: ‘What is
prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.’ If
commodities could be purchased abroad more cheaply than they could be made at home, then
it would be foolish to put obstacles in the way of importing them. Such restrictions could only
impede the welfare of the whole community.
The critique of mercantilism, together with the case for free trade, is contained in books III and
IV of Wealth of Nations. There are three powerful ideas to bear in mind in the remainder of this
chapter:
● A nation’s wealth depends on its productive capacity. Gold and silver do not of themselves
constitute a nation’s wealth. Gold and silver can be ‘wasted’ on luxury spending. But if gold and
silver are used to purchase materials and tools, or to employ labour, then productive capacity
and future wealth is assured.
● Laissez-faire is the best way to increase productive capacity. Governments should remove
restrictions and privileges to permit the expansion of industry and trade. Once freed from the
burden of the state, social harmony and economic progress will triumph.
● International trade is mutually beneficial for all trading countries. Every country benefits from
being able to export those commodities which it produces efficiently, and being able to import
those commodities which it produces inefficiently. There are no ‘losers’ from free trade. All are
‘gainers’.
Absolute advantage
Smith claimed that a country should specialize in, and export, commodities in which it had an
absolute advantage. An absolute advantage existed when the country could produce a
commodity with less labor per unit produced than could its trading partner. By the same

5. reasoning, it should import commodities in which it had an absolute disadvantage. An absolute
disadvantage existed when the country could produce a commodity only with more labour per
unit produced than could its trading partner.
Table 2.1 is a simple arithmetical example of the principle of absolute advantage. The countries
in the table (the UK and the US) are not, of course, the ones familiar to Smith, nor are the
commodities (wheat and cloth) the ones which feature in Wealth of Nations, but the principle is
universal. To simplify matters, we will continue to use these two commodities and countries
whenever we are dealing with the two-country, two-commodity case.
Table 2.1 indicates that the UK has an absolute advantage in cloth production and an absolute
disadvantage in wheat production. The US has an absolute advantage in wheat production and
an absolute disadvantage in cloth production. Both countries will gain if the UK specialises in
cloth and exports it to the US, and the US specialises in wheat and exports it to the UK. In
modern terminology, trade is a positive sum game. Everyone gains from specialisation and
exchange, though we may note from the outset that there is no reason to expect everyone to
gain equally.
Labour theory of value
The classical economists, of whom Smith was the first, regarded labour as the sole source of
value. The quantity of labour embodied in a commodity measured the value of that commodity.
The arithmetical example of Table 2.1 is consistent with a labour theory of value, since the
exchange value of each commodity is determined by the amount of labour time (output per unit
of labour) necessary for its production. The classical writers operated with a labour theory of
value. Although Smith had not developed a price related demand schedule in the modern sense
he did recognize that demand for acommodity needed to be taken into consideration. Producers
in search of profit would not continue to produce commodities for which there was no market.
Market demand was needed if producers were to cover their costs of production. Market
demand would determine what commodities were to be exchanged and the relative amounts to
be produced.
Table 2.1 Absolute advantage (arithmetical example)
Output per unit of labour
Production of wheat
Production of cloth
UK
US
5
20
10
6
Smith also recognised that workers differed in aptitudes and abilities. The lazy and unskilled
worker would be less productive than the industrious and skilled worker. It is labour, as opposed
to the labourer, which is the measuring rod in the labour theory of value. Labour, Smith claimed,
was alone ‘the ultimate and real standard by which the value of all commodities can at all times
and places be estimated and compared’

6. Comparative advantage
1817, David Ricardo - Even if one country has an absolute advantage in producing two
products over another country, trading with that other country will still yield more output
for both countries than if the more efficient producer did everything for themselves.
David Ricardo asked what might happen when one country has an absolute advantage
in the production of all goods. Ricardo’s theory of comparative advantage suggests that
countries should specialize in the production of those goods they produce most
efficiently and buy goods that they produce less efficiently from other countries, even if
this means buying goods from other countries that they could produce more efficiently at
home.
The country with the absolute advantage in producing both products would still produce
both products, but less of the one they would trade for, allowing them to essentially
allocate more resources to producing the product that they’re comparatively most
efficient at producing
Assumes many things:
o Only 2 countries and 2 goods
o No transportation costs
o No price differences for resources in both countries
o Resources can move freely from producing one product to producing another
product
o Constant returns to scale
o Fixed stock of resources
o Free trade does not affect production efficiency
o No effects of trade on income distribution within a country
There are some descriptions of potential outcomes of relaxing some of these
assumptions, but I’ll leave this as a thought exercise for you, the reader
Specialization and trade should occur according to the relative opportunity costs of
production in each country, measured in terms of the alternative production given up to
produce a tradable good.
Example:
resources required per unit output:
Tea
Wheat
Sri Lanka
10
10
United States
5
4
The opportunity cost of tea in Sri Lanka is 1 unit wheat; the opportunity cost of tea in the
US is 1.25 units wheat. Sri Lanka has comparative advantage in tea production, despite
its absolute disadvantage in the production of each commodity.