Theory of Comparative Advantage
The theory of comparative advantage just explains such advantages of free trade. David Ricardo (The Principles of Political Economy and Taxation 1817) shown that trade without barriers can be beneficial for two countries if one is more efficient at producing goods or services needed by the other. What matters is not the absolute cost of production, but rather the ratio between how easily the two countries can produce different goods. Thus, according to the theory of comparative advantage, if countries specialize in producing what they are most efficient, then they can trade these goods for those produced most efficiently by other country.
The concept of comparative advantage can be illustrated with at least two goods and two countries where each good could be produced with scarce resources in each country. Suppose the two goods are food and clothing, and that the price of food within country 'A'is 0.50 units of clothing and the price of clothing is 2 units of food. The price of food in country 'B' is 1.67 units of clothing and the price of clothing is 0.60 units of food. Then we can say that country 'A' has a comparative advantage in producing food and country 'B' has a comparative advantage in producing clothing. It follows that in a trading relationship the country 'A' should allocate at least some of its scarce resources to producing food and country 'B' should allocate at least some of its scarce resources to producing clothing, because this is the most efficient allocation of the scarce resources and allows the price of food and clothing to be as low as possible.
Hence, the theory argued that free trade will benefit all due to comparative advantage.
Contribution of foreign trade to economic development
Foreign trade has worked as an 'engine of growth' in the past. Recently the 'outward-oriented growth strategy' adopted by the Newly Industrializing Economies of Asia, has enabled many countries to overcome the constraints of small resource-poor under-developed economies. Foreign trade contributes to economic development in a number of ways as follows.
It explores means of procuring imports of capital goods, which initiates the development process.
It provides for flow of technology, it allows an increase in factor productivity.
It generates pressure for dynamic change through (i) competitive pressure from imports, (ii) pressure of competition for export markets, and
a better allocation of resources.
Exports allow fuller utilization of capacity, increased exploitation of economies of scale, separation of production patterns from domestic demand, and increasing familiarity with absorption of new technologies. These, in turn, help increase the profitability of the domestic business without any corresponding increases in price.
Foreign trade increases worker's welfare. It does so at least in four ways:
larger exports translate into higher wages;
because workers are also consumers, trade brings them immediate gains through cheaper imports;
It enables most workers to become more productive as the goods they produce increase in value;
trade increases technology transfers from industrial nations to UDCs and the transferred technology is biased in favour of skilled labour;
Increased openness to trade has been strongly associated with the reduction of poverty in most developing countries.
In the twenty-first century, we can easily identify the conditions that are favourable for developing economies to the conditions to employ foreign trade as a factor in economic growth. They are as follows:
Increasing spread to globalization translates into larger movement of goods and services across the nations.
Continuing reallocation of manufacturing activities from industrial economies to developing economies offers ample opportunities to expand trade not only in goods, but also in services, which are becoming increasingly tradable.
Trade is intertwined with another element of globalization: the spread of international production networks.
Growth of trade is firmly buttressed by international institutions of long standing. The WTO, built on the legacy of the GATT, aims to create a commercial environment more conducive to the multilateral exchange of goods and services.
In recent years there have been substantial reductions in trade policy and other barriers inhibiting developing country participation in world trade. Lower barriers have contributed to a dramatic shift in the pattern of developing country trade-away from dependence on commodity exports to much greater reliance on manufactures and services. In addition, exports to other developing countries have become much more important.