Question

Review Smith’s argument for international free trade. How did Ricardo improve on Smith’s theory in this regard?

Answer 1

The trade theory that indicates the importance of specialization in production of one good and the division of labor was initially based on the idea of Adam Smith's theory of Absolute advantage. It States that a country should specialize in the production of good in which it has an absolute advantage(the ability of an country to produce greater amount of goods than the other country using the Same amount of resources). So, if country A has an AA in production of good X and country B has an AA in production of good Y, then country A should specialize in production of X and country B should specialize in production of Y while trading with each other. Thus they don't need to produce both goods in home country.

David Ricardo improved Smith's argument for international trade by extending it to the theory of comparative advantage and showed that it's the reason why countries should engage in free trade and trade will be mutually beneficial for both countries. According to Smith, country should specialize in production of good in which it has an AA. But what happens if a country has AA in production of both goods? The answer comes from Ricardian theory of comparative advantage. It states, a country should specialize in the production of good in which it has comparative advantage (lower opportunity cost of production than the other country) and lower relative price in autarky than found in the other country. This theory indicates we need to consider the cost of production in each country before trade and compare it with after trade situation to compute gain/losses.