Distinguish between Classical Theory and Neoclassical Theory.

Classical theory known as Ricardian theory of comparative advantage states that two countries should trade in order to increase their national welfare as long as each has a comparative advantage in the production of one good versus another. In the classical theory, it is the difference in technology that forms the basis of comparative advantage and mutually beneficial trade.

But Neoclassical theory known as factor abundance theory states that differences in relative factor endowment forms the basis of comparative advantage. Neoclassical theory is seen as an extension of classical theory.

Following are the major points of distinction between Classical Theory and Neo-classical Theory:

In Classical Theory, it is the difference in the technology that determines the position of trade. It is the technological difference between two trading countries as reflected in their respective labor productivity ratio, which form the basis of trade. Classical theory does not consider how much labor (a factor) each country has. In contrast to Classical Theory, Neoclassical Theory, it is the difference in the, factor endowments that determine the pattern of trade. It is the difference in relative factor endowment between two trading countries which form the basis of trade.

The Classical Theory has an assumption that production in all the countries is subject to constant returns to scale. But Neoclassical Theory has released the assumption of constant returns to scale in order to allow for decreasing return to scale.

The Classical Theory believes that two countries differ in technology to produce the goods. Neoclassical Theory believes that two countries have the same technologies to produce goods.

The Classical Theory believes that labor is the only source of value of goods produced in the economy in contrast to Classical Theory. The Neo-classical Theory assumes that there are at least two factors of production labor and capital which are used in the production of goods. Two countries differ only in respect of relative factor endowments: one country being relatively labor-abundant and the other relatively capital-abundant. A country exports those goods that use intensively, its relatively abundant factor of production.

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