Adam Smith on the Benefits of Trade

Adam Smith’s theory of foreign trade was found wanting by most economists until recent times. Unlike Ricardo’s Principles of Political Economy, Smith’s Wealth of Nations contains no chapter titled “On foreign trade”.

The long dominance of Ricardo over Smith - of comparative advantage over increasing returns - was largely due to the belief that the alternative was necessarily a mess. In effect, the theory of international trade followed the perceived line of least mathematical resistance. Once it was clear that papers on noncomparative-advantage trade could be just as tight and clean as papers in the traditional mold, the field was ripe for rapid transformation. (Krugman 1990: 4)

As noted below, Krugman’s new trade theory has indeed some parallels with Smith’s theory of foreign trade, though he expressed it in the mathematical terms that the eco­nomics profession is now accustomed to. Smith’s most significant statements on foreign trade occur in the early chapters of Book IV of the Wealth of Nations where he launches his broadsides against mercantilism. The gains from foreign trade are highlighted in chapter 2 titled “Of restraints upon the importation from foreign countries of such goods as can be produced at home”. Positive and normative elements of trade theory (with the emphasis on normative ones) are treated simultaneously by Smith who contends that:

The natural advantages which one country has over another in producing particular commodi­ties are sometimes so great, that it is acknowledged by all the world to be in vain to struggle with them.... Whether the advantages which one country has over another, be natural or acquired, is in this respect of no consequence. As long as the one country has those advantages, and the other wants them, it will always be more advantageous for the latter, rather to buy of the former than to make.

Though he frequently uses the term “advantage” in this chapter, Smith never defines it rigorously. Most trade economists believe it stands for “absolute advantage” or a lower cost of production, a term to which I return below when comparing it to Ricardo’s com­parative advantage. One of Smith’s goals for foreign trade is clearly the efficiency one of using it to minimize the overall cost of providing a given level of consumption by selling domestic commodities at the highest price and buying foreign ones at the lowest.

In certain cases Smith attributes advantages to the abundance of particular factors of production such as land in Britain’s American colonies. Bloomfield (1975: 459) even claims that Smith anticipated the Heckscher-Ohlin theory of trade discussed below, arguing that Smith “lays down with remarkable clarity the elements of the proposition later to be made famous by Heckscher and Ohlin”. But this is developed by example rather than in any systematic way. As Bloomfield himself recognizes, of greater impor­tance to Smith than the causes of trade is its economic impact, or what has become known as the “gains from trade”. As an important expression of the efficiency advantages just mentioned, Smith repeatedly applies the eighteenth-century rule to personal exchanges, exchanges between town and country, and international ones. As a secondary benefit he lists the gains that consumers enjoy beyond the purchase of cheaper goods, such as the availability of a greater variety of commodities, including some imported from America that were previously unknown. Unlike in the case of present-day mainstream trade theory, the third and most important gain occurs on the production, not the consump­tion, side: it is the stimulus to economic development occasioned by a widening of the market. According to Smith, the key to a nation’s wealth is the division of labour, and this is limited by the extent of the market. When international trade enhances this extent by adding the foreign to the domestic market, it enables a greater division of labour and a gain in efficiency.

By opening a new and inexhaustible market to all the commodities of Europe, it gave occasion to new divisions of labour and improvements of art, which, in the narrow circle of the ancient commerce, could never have taken place for want of a market to take off the greater part of their produce. The productive powers of labour were improved, and its produce increased in all the different countries of Europe, and together with it the real revenue and wealth of the inhabitants. (WN IV.i.32)

Myint (1977) called this Smith’s “productivity theory of trade”. It claims that the gains from trade are mainly dynamic rather than static, as they are in neoclassical trade theory where the economy moves along a given transformation curve in the direction of greater specialization, with no effect on technology or the “productive powers of labour”. Other dynamic benefits that Smith mentions, possibly borrowing from his friend Hume’s writ­ings, are the incentive that the availability of foreign goods provides for greater work effort, and for the adoption and imitation of foreign technologies. A stimulus to eco­nomic development via import substitution and the activation of otherwise idle resources thanks to export demand are additional benefits of foreign trade that Smith emphasizes in the Wealth of Nations. In addition to Smith, other classical economists (including David Hume and John Stuart Mill) pointed out that international trade, in addition to its economic gains, also provides a set of non-economic benefits, such as the promotion of friendship and solidarity among nations, and even makes war among them obsolete.