One of the major aims of Smith's Wealth of Nations was to demonstrate the falsity of the rather extensive set of ideas now called mercantilism—about 25 percent of his book is devoted to an examination of mercantilist doctrine and practice. Some mercantilists argued that government regulation of foreign trade was necessary in order for a country to have a so-called favorable balance of trade—exports greater than imports—and, therefore, an increase in the quantity of bullion, as other countries paid in precious metals for the home country's excess of exports over imports. Interestingly, we still use the term "favorable balance of trade" to describe a situation in which a country gives others more goods than it gets in exchange, the difference being settled through payments of gold or IOUs. A favorable balance of trade, however, is favorable only if one incorrectly believes that the wealth of a nation depends upon its holdings of precious metals.
Smith, on the contrary, argued for unregulated foreign trade, reasoning that if England can produce a good, e.g., wool, at lower costs than France, and if France can produce another good, e.g., wine, at lower costs than England, then it is beneficial to both parties to exchange these goods, with each trading the good it produces at lower costs for the good it produces at higher costs. In the language of economics, this became known as the absolute advantage argument for foreign trade. This argument, moreover, is not limited to international trade. It applies to trade within a country as well.Embedded in Smith's analysis of how markets develop dynamically over time, one finds another argument for free international trade. Although Smith never fully developed this argument, later economists were able to infer it from the Wealth of Nations. We have already seen that Smith held that a key determinant of the wealth of nations was the productivity of labor and that labor productivity depended primarily upon the division of labor. As labor becomes more divided and specialized, he pointed out, its productivity increases dramatically. Smith held that differences in individual abilities, and hence productivity, were largely the effects of the division of labor, not its cause. At birth, Smith asserted, we are all similarly talented; it is only after we begin to specialize in various activities that we become more proficient relative to others who do not so specialize. We learn by doing, becoming progressively able to produce our goods more cheaply as we get more efficient in our specialized tasks.
In the language of modern economics, there are increasing returns (decreasing costs) as labor becomes more and more specialized. Part of Smith's argument for the advantages of foreign trade was broadly based on this dynamic notion of increasing returns. He realized that if two individuals are equally talented at birth and their talents remain unchanged, it follows that there are no advantages to either of them if they specialize and trade their goods. (The nationality of the individuals makes no difference to these arguments—i.e., whether one person is English and the other French.) If, however, two individuals become more proficient by labor specialization, the costs of producing both their products decrease and both benefit by specializing and trading. Out of this insight of Smith's arose the recognition, pivotal for the development of free trade, that dynamically over time any nation might achieve absolute cost advantages in the production of certain goods through specialization and division of labor, and that all nations could gain from the resulting international trade.
Smith, who was very policy-oriented in his analysis of international trade, criticized, in particular, mercantilist policies that had restricted the quantity of trade, concluding that those policies erroneously assessed the wealth of a nation as consisting of the bullion the nation held, rather than correctly defining a nation's wealth as a flow of goods. The proper governmental policy toward international trade, Smith held, should be the same as that toward domestic trade—one of letting voluntary exchanges take place in free-unregulated markets. A policy of laissez faire, he believed, would lead to ever higher levels of well-being in all countries.
Modern economics, in assessing the dominant ideas of this period, has discovered another difference between the classicals and the mercantilists that significantly influenced their views concerning the relative importance of free markets versus government regulation. These differences, though never fully articulated in either Smithian or subsequent classical economics, are fundamental to classical views on the consequences of economic activity and remain fundamental even today. They have to do with the fact that if one holds that the total quantity of resources on our planet is fixed, then a process of exchange between two individuals or nations must require that one gain and the other lose. In the language of some modern economists, an economic exchange is a "zero-sum game, " in which there is a winner and a loser. Thus, when Britain trades with France, if one gains by this exchange, the other must lose. An opposing perspective holds that economic exchanges are not zero-sum games, that both parties can benefit from the exchange. To rigorously prove that all countries can benefit from foreign trade, one must show that there are more goods in the world after the exchange than there were before. While this sort of book is not the place to demonstrate such a proof, some introductory economics texts do show how foreign trade benefits both parties and that the total amount of goods in the world is greater after the exchange.
This insight of Smith and other classical writers that, contrary to the beliefs of many mercantilists, all parties might gain from trading provided a tremendously powerful argument for voluntary exchanges, whether between individuals within a country or between different countries.