By stressing the advantages of the principle of division of labour, Adam Smith developed his theory of international trade in support of free trade as a vigorous attack upon mercantilist foreign trade policies of protectionism.
He argues that since division of labour is very advantageous in production, free international trade is desirable as it promotes international division of labour, because it causes each country to specialise in those goods which it is best suited to produce most cheaply! He held that, free trade between countries brings about an optimum allocation of the productive resources of the world, leading to an enhancement of real income of the trading countries.
In this context, Adam Smith developed the law of absolute cost advantage for international trade. According to him, trade occurs between two countries if one of them has an absolute advantage in producing one commodity and the other country having absolute advantage in producing some other commodity. To elucidate the point, let us observe the following illustration.
Suppose there are two countries, A and B. For simplicity’s sake, like the classical economists, we shall measure all costs in terms of labour. Then, if in country A, one unit of labour per day can produce, let us say, 25 barrels of wine or 10 bales of cloth, in B, the same amount of labour can produce 10 barrels of wine or 15 bales of cloth. The position then is as follows:
Evidently, A has an absolute cost advantage over B in the production of wine (for 25 barrels are more than 10 barrels), while B has an absolute advantage over A in the production of cloth (for 15 bales are more than 10 bales).
Thus, country A will specialise in the production of wine in which it has an absolute cost advantage over B and country B will specialise in producing cloth in which it has an absolute advantage over A.
The trade between the two countries, then, will benefit both of them. As it is easy to see, with 2 units of labour, A will now produce 50 barrels of wine and B 30 bales of cloth as a result of specialisation and international trade. In the absence of this, there will be only 35 barrels of wine and 25 bales of cloth produced by both the countries with their given 2 units of labour.
Though, Smith’s theory is clearly expressed, it is not convincing. It is based on the assumption that international trade required a producer of exports to have an absolute cost advantage, that is, an exporting industry must be able to produce with a given amount of capital and labour, a larger output than any rival. But then, what about the export phenomenon of a country having no such clear superiority in any line of production?
This may be the case of a relatively backward country whose factors of production, as compared with those of any other developed nation, are inefficient in all lines of production. There is no absolute advantage for such a backward country and yet we find that it has international economic relations. Adam Smith’s theory clearly fails to analyse this sort of situation.
It thus, appears that international trade cannot always follow the doctrine of absolute cost advantage, and a new principle is inevitably to be sought.