Classical Trade Theory

Classical trade theory has evolved over time beginning with mercantilism during the 16th, 17th, and 18th century when the strategy of the rulers was to increase wealth (gold and silver) by encouraging exports and hindering imports. The wealth of the country increases if its exports more than its import getting more gold and silver out of the exchange. The mercantilism ideas declined due to the coming of the industrial revolution and of laissez-faire (Columbia University, 2013).

In 1776, Adam Smith in his book “The Wealth of Nations” argued in favor of free trade that mercantilist policies are for the benefit of producers not the consumers. He considered labor productivity as the only input and defined absolute advantage as case where a country is able to produce a product or service at less cost than other countries, using the same amount of resources. So, the mutual benefit of trade between two countries does not occur unless each country has a product with absolute advantage (Vurgun, 2013).

In 1817, David Ricardo articulated in his book “On the Principles of Political Economy and Taxation” that each country can get advantage of trade even if it has no absolute advantage in any of its products emphasizing the importance of the comparative difference in cost not the absolute difference in cost. The concept of opportunity cost has an obvious application in David Ricardo’s ideas about trade since countries specialize in the production of commodities that have less opportunity cost and trade with each other (Vurgun, 2013). One of the dominant models of comparative advantage is the Heckscher-Ohlin theory emerged in the early 1900s stressing that the abundance of resources in a country is determinant for the goods to be produced and exported or imported.

In order to toughly understand David Ricardo’s theory, the theory’s assumption should be clearly displayed. According to Carbaugh (2011), David Ricardo based his theory on the following assumptions:

1. Two...