Major Differences between Adam Smiths and David Ricardos Theories of International Trade - Term Paper Example

International Economics: What do you consider to be the major differences between Adam Smith's and David Ricardo's theories of international trade The basic concept underlying all international transactions is that foreign markets are extensions of domestic markets, in the sense that goods and services produced domestically, and whose quality is reflected in the strengths of the supply and demand curves, can also be sold internationally. This market-extension concept allows for the developing of markets in different countries, regardless of the domestic market conditions. Traditionally, the significance for foreign trade is that it provides an outlet for a country's goods and services, so that employment is maintained and profits continue to increase. For this reason, classical and neoclassical economists emphasized the comparative advantage of trade, and the basis for establishing trade among partners whose advantage in production of different goods and services warranted the international exchanges. The key theorists who have introduced the notion of international trade were Adam Smith and David Ricardo. The foundations of their theories and major difference of viewpoints are the subject of this paper. Ricardo's view on international trade was based on the concept of comparative advantage. This principle is an advance on that of absolute advantage in the sense that a country suffering absolute disadvantage in the production of every commodity could still gain from trade. However, the comparative advantage theory bypasses the importance of the division of labor in the explanation of trade as well as growth. It is possible that Ricardo was only interested in putting forward additional arguments for free trade so as to avert the declining rate of profit and consequently the onset of the stationary state, for which the theory of comparative advantage came in handy. In any case, Ricardo's main concern was not to develop a theory of international trade but to show how distribution of income among various classes affected capital accumulation and growth. Also, in his preface to The Principles of Political Economy and Taxation he mentioned that he wanted to confine himself to aspects of political economy on which he differed from Smith. It is therefore possible that Ricardo did not develop the theme of the division of labor as an explanation for growth or international trade because he saw no reason to differ from Smith on this. Another major input of Ricardo is maid in his work Essay on the Influence of a Low Price of Corn on the Profits of Stock. Here the author laid out the idea of law of diminishing returns as it applied to labor and capital. The theory describes the land's value determined by the demand for the land. As industry expanded, land would appreciate in value according to its scarcity and location, with respect to industrial demand. There was also the demand for dwelling space as well as for agricultural output; as land became exhausted or of marginal use, its value would depreciate accordingly. Ricardo also emphasized output, internal efficiency in industrial output, as well as entrepreneurship in the mustering of capital and resources for production. The Malthusian problem was certainly known to Ricardo, as Malthus and Ricardo engaged in extensive correspondence. But Ricardo maintained that the Malthusian situation could be offset by the value of land for agriculture fluctuating with respect to its supply and demand conditions. When agricultural land becomes scarce and its value increases, more people will be attracted to that profession; efficiency in agriculture would lead to greater crop yields, corresponding to the demand for foodstuffs, thereby preventing the Malthusian famine situation1. Ricardo considered foreign economies as extensions of the domestic economy, so that foreign commerce could be treated from a perspective similar to domestic commerce. This enabled him to formulate his theory of trade on the basis of comparative production costs, so that if product x costs more to produce in country A than in country B, and similarly, if product y costs more to produce in country B than in A, and if each country requires both products, then A would produce y more cheaply than x and B would produce x more cheaply than y. The countries would export to each other the surplus of their products not consumed by their domestic populations. This is how the various sectors are developed within an economy, and in the same manner they are developed internationally. This concept of comparative costs provided the basis for Mill's theory of comparative advantage in trade2. For Adam Smith, international trade is just the natural extension of the process of market creation. Smith considers that movements that limit trade will result in a decrease in the value of national output and productive labor. He is arguing that such a move away from the allocation of resources established by the market would cause the productive power of labor to be diminished through two related mechanisms. First, smaller investment opportunities cause an increase in revenues and hence causing less productive labor to be employed and converting productive labor to unproductive labor. Secondly, the decline in the extent of the market causes a reduction of expenditures in the division of labor in this way diminishing the productive power of labor. Resources are mobile in Smith's theory of international trade; they are merely moving from the more productive to less productive uses as he defines them. This last point is demonstrated when Smith says that if the colonies were to artificially decrease imports of manufactured goods from Europe, "they would retard instead of accelerating the further increase in the value of their annual produce, and would obstruct instead of promoting the progress of their country towards real wealth and greatness"3. Ricardo's theory also had the clearing mechanism of the markets. When costs become too high, alternatives are found at lower costs, thereby bringing these alternatives into economic use. The demand for these alternatives eventually leads to the rise in their use costs due to scarcity, and they will rise, with the resultant decline of the previous costs. Even land that has become uneconomic due to its overuse will become economic over time as other land that substituted at lower costs becomes increasingly expensive due to continuous demand. Comparative costs were important in international trade as the costs of goods imported declined and then rose over time with respect to domestic goods. The "invisible hand" of Adam Smith and Say's Law were prevalent in Ricardo's theory, and this, indeed, was another expression of Hume's Law. However, Ricardo's consideration of foreign markets within the same theoretical context as domestic markets was invalid, in spite of the significant contribution he made to economic theory. This could be attributed to the fact that when he wrote, the Industrial Revolution had not developed to the extent that it had during John Stuart Mill's time, so that tariffs and banking systems had not developed to the extent that they had during Mill's time. David Ricardo was certainly one of the pillars of economics on which Mill and other great economists have stood to expand their vision. Ricardo's approach to economics differed significantly from that of Adam Smith. Ricardo only introduced the theories from which he made conclusions described in the previous parts of the paper. His most imperative assumption was that economic growth must decline and end due to the scarcity of land and its falling marginal productivity. Meanwhile, Adam Smith's theory argues that foreign trade vents surplus products is necessary to maintain or generate a full utilization of a country's resources. Smith contribution to the theory of international trade is laid in his book Wealth of Nations where the author advocates a system of natural liberty of markets to allocate resources freely across the countries. Otherwise, "without such exportation, a part of the productive labour of the country must cease, and the value of its annual produce diminish"4. Mercantilism was strictly a British approach to economic wealth and differed radically and indeed contrasted with its French counterpart of physiocracy. In the cool rationalism for which French thinking is traditionally famous, physiocracy was a philosophical-cum-economic theory that maintained that a country's wealth stems from the productivity of its soil. Agriculture was the most important industry, for it provided the food necessary for feeding the population. On the basis of surplus foodstuffs, trade would enable these surpluses to be exported for goods and services not obtainable--either in sufficient quantities or at all--from the domestic markets. The greater the crop yield, therefore, the hardier the livestock yields, the healthier the population, and the stronger the economic position. The mercantilist school both differed from and rejected the logical physiocracy of the French. In the tradition of empiricism and experimentation that had developed in Great Britain, the British approach maintained that a nation's wealth is based solely on its trading prowess. For this, it was of no significance whether the goods traded were domestic in origin or acquired from other lands. Wealth was proclaimed in coin obtained by trading more than was received in goods and services with surpluses made up in coin, thereby possessing a claim on the trading partner's economy. This situation was termed the favorable balance of trade and this was sought on the part of the British exporters to acquire surplus foreign coin. The difference between the mercantilist and physiocratic approaches to trade was also manifested in their respective approaches to exploration. Both the British and the French engaged in the expansion of their countries' power by encouraging military conquests of lands. The British, as subjects of an island country, were very aware of the burden of markets placed on them by their geographical separation, and while they did not neglect the fertile lands of their agricultural sectors, they did recognize their limited space and the lack of resources. By obtaining the natural resources of other lands and by mobilizing the peoples in these lands into cheap labor, they could direct their activities to foreign commerce and obtain foreign currencies to continue their activities. The French approach to exploration was not so much as to conquer other peoples, but to obtain new agricultural lands so that their produce could be traded under French rule and in French coin. The French enslaved conquered peoples to till the soils and increase agricultural yields, so that surplus crops and agricultural by-products could be traded for finished goods and services. These two different philosophical and practical approaches found common ground in the reasoning of Adam Smith. His French was sufficient to allow him to engage in deep philosophical and economic discussions with Dr. Francois Quesnay, the main spokesman for the physiocratic school; he also debated with Quesnay's followers. With Smith's background in the mercantilistic tradition, and his participation in the debates with Quesnay and his school, the ideas were formulated into the theory stated in the Wealth of Nations. Smith recognized that the degree and kinds of enterprise existing in Great Britain and France were not, in themselves, adequate for economic expansion. Guilds and other forms of unions that protected their members' status and the qualities of their trades were limiting both economic expansion and growth. Instead, he argued for private and free enterprise in which individuals take the risks and reap the profits or bear the losses, as the case may be. While Smith considered agriculture to be of prime importance, he nevertheless deflated its physiocratic significance and placed it soundly within the economic function of feeding the populace. Surplus agricultural produce could most certainly be exported and goods and services not provided by the domestic economy imported. Hence, for Smith, international commerce should not be neglected, as it is important for stimulating production and earning foreign coin. However, emphasis should be placed on individual initiative and enterprise as the means of building national wealth because enterprise brings standard and new products into the markets and stimulates new demand and competition. Therefore, both agricultural development and the establishment of domestic and foreign markets should be both the consequences and the supportive factors of private enterprise.5 Indeed, Smith argued that the total industry of a country cannot be out of proportion with its total capital. So any artificial direction to economic activity, say by tariffs or import restrictions, misdirects a country's capital from more productive employments to less. (4) This indeed is why Smith was against the mercantilist policies of governmental interference and the associated parasitic apparatus they spawned. For Smith, therefore, the theory of growth and the theory of international trade were two sides of the same coin. As Hla Myint argued, "Smith's theory of foreign trade is so closely interwoven with his theory of domestic economic development that the two have to be considered together" (1977, 231). Historically, the impact of the Wealth of Nations is that it pointed inward to the development of the national economy, based on individual initiative and enterprise. Smith's analysis of the division of labor was of such importance for the Industrial Revolution that had just begun when his book appeared that the readers of the Wealth of Nations paid little or no attention to his comments on international trade. The focus of Smith's followers was mainly internal, on the domestic economy and the establishment of entrepreneurship and the division of labor as the factors of economic growth and development. In the end, the theory of international trade of Ricardo and that of Smith were different in terms of the concepts introduced in the theory. Smith's theory of international trade was based on the concept of the division of labor that widened the market and gave vent to the resources which, in the absence of trade, would remain unemployed or underemployed. International trade, by overcoming the narrowness of the domestic market, ensures that the division of labor is carried to the highest perfection. This in turn increases the productive powers of a nation and augments its annual produce to the utmost. Ever since David Ricardo couched his explanation of trade in static terms, the valuable insights of Smith regarding growth and international trade and their link with increasing returns became almost forgotten. Ricardo's explanation of trade was in terms of comparative advantage, which showed only the static gains from trade. The neoclassical theory of comparative advantage, which predominates now, is essentially Ricardian in spirit as it bypasses the role of the division of labor in international trade. Bibliography: 1. Classical Economics: An Austrian Perspective on the History of Economic Thought, by Murray Rothbard, vol. 2, Hants, UK: Edward Elgar, 1995, pp. 96-98. 2. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. Edwin Cannan ( New York: Modern Library, 1937), esp. pp. 420-55. 3. Jacob Viner, Studies in the Theory of International Trade ( London: Allen and Unwin, 1937), p. 291. 4. David Ricardo, Principles of Political Economy and Taxation ( New York: Dutton, Everyman, 1911), esp. Chap. 7, for his treatment of comparative costs. 5. "David Ricardo's Discovery of Comparative Advantage," by Roy J. Ruffin, History of Political Economy, vol. 34, Winter 2002, pp. 727-48. Read More