Pure theory of international trade:
Based on the considerations of absolute advantage, Adam Smith argued as to how countries can gain through international trade. This forms the basis for the pure theory of international trade. The theory of absolute advantage can be explained through a simple example. Suppose two goods A and B can be produced by labour alone. It takes 100 units of labour to manufacture one unit of good A in country Xbut 200 labour units in country Y Conversely, it takes 200 units of labour to manufacture one unit of good B in country X but only 100 labour units in country Y: In other words, country X is more efficient in producing good A, because it uses less labour per unit of output than country Y: By the same logic, country Y is more efficient in producing good B.Then country X is said to have the absolute advantage in producing good A, while country Y has an absolute advantage in producing good B.
Now country Y may gain by producing one unit of B, using 100 labour units, and exporting it to country Xin exchange for one unit of A. In effect, country Y has used 100 labour units to obtain one unit of A indirectly, rather than using the same labour to produce 0.5 unit of A directly. Correspondingly, country X must have used 100 units of labour to produce the unit of A for export, in exchange for which it received one unit of B. But if it had tried to produce one unit of B itself, it would have required 200 units of labour. Thus, it may be concluded that by trading, both countries could have gained by having more of both goods.
The above example clearly demonstrates that two countries can gain through international trade if they have absolute advantage in producing different goods. However, gains from international exchange of goods need not be limited to the situations of absolute advantage. It was later shown by Ricardo as to how the benefits from trade can be reaped also in situations of comparative advantage, which came to be known as the theory of comparative advantage.