Absolute advantage International Trade, Comparative Advantage Trade Theory

Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade. He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations. The free trade, according to Smith, promotes international division of labour. Absolute advantage is important for explaining why some countries produce goods or services more efficiently than others. According to this theory, each should focus on these advantages when producing goods and services. And then, international trade facilitates them to get other goods which are less efficiently produced domestically.

As a result, Blue Country will be better off if it specializes in the production of Good A. This assumption means that we cannot have trade imbalances, trade deficits, or surpluses. A trade imbalance occurs when exports are higher than imports or vice versa. Governments implement trade barriers to restrict or discourage the importation or exportation of a particular good.

1. As a result, Blue Country will be better off if it specializes in the production of Good A.
2. A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product.
3. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn.
4. In some industries, businesses will work with governments to create immigration opportunities for workers that are essential to their business operations.
5. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receives in exchange an amount of oil greater than 20 barrels, it will gain from trade.

So the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced.

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The absolute advantage was introduced by Adam Smith in the late 18th century. When we learn about international trade, this theory becomes the main introduction, in addition to comparative advantage. Similarly, to specialize in the production of cloth if India withdraws 10 hours of labour from wheat and use them for the production of cloth, it will lose one unit of wheat but gain 2.5 units of cloth. Adam Smith had believed that absolute advantage was a necessity for beneficial trade.

Japan has an absolute advantage in electronics manufacturing due to its highly skilled workforce and advanced technology. As a result, it specialises in electronics manufacturing and exports electronic products to other countries. It does not explain the possibility of specialisation and international trade if one country has an absolute advantage in both goods.

A Numerical Example of Absolute and Comparative Advantage

Therefore, Portugal has an absolute advantage in the production of wine. Specializing in and trading products that they have an absolute advantage in can benefit both countries as long as they each have at least one product for which they hold an absolute advantage over the other. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the generated funds to purchase goods and services from other countries. Adam Smith also emphasised that specialisation on the basis of absolute cost advantage would lead to maximisation of world production. The gains from trade for the two trading countries can be shown through Table 2.2.

The specialisation decision will be made by using the maximum output table. Let’s use a data example to better understand the concept of absolute advantage. The Absolute Advantage Theory assumed that only bilateral trade could take place between nations and only in two commodities that are to be exchanged. Such an assumption was significantly challenged when the trade, as well as the needs of nations, started increasing. Thus, the theory did not take into account the multilateral trade that could take place between countries.

1 What Is International Trade Theory?

In Indonesia, on the other hand, the opportunity cost is 2 shoes (6/3). Therefore, because Malaysia has a lower opportunity cost, it has a comparative advantage in clothing. It will be seen from the above table that to produce one unit of wheat in the U.S.A. 3 man-hours and in India 10 man-hours are required. On the other hand, to produce one unit of cloth, in the U.S.A. 6 man-hours and in India 4 man-hours are required.

As a result, it specialises in textile production and exports textiles to other countries. The theory assumes a constant opportunity cost, but in reality, the opportunity cost may not be constant, especially if resources are not homogeneous or if the production process becomes more complex. It can be noted from above two cases, that the total world absolute advantage theory output (TWO) is increased due to specialisation. But the problem is that country A does not have tables and country B does not have chairs. Unlike the country-based theories, firm-based theories incorporate other product and service factors, including brand and customer loyalty, technology, and quality, into the understanding of trade flows.

Mexico produces 4,000 pairs of shoes and 5,000 refrigerators, for a total of 9,000 shoes produced, and 25,000 refrigerators produced. It identifies the good where the absolute advantage is relatively larger, or where the productivity disadvantage is smaller. Absolute advantage is determined by comparison of labor productiveness, so it is possible for a party to have no absolute advantage. The unit cost is a crucial measure to determine operational analysis of a company.

Thus the U.S.A. can produce wheat more efficiently (that is, at a lower cost), while India can produce cloth more efficiently. The basis for trade in the Ricardian model is differences in technology between https://1investing.in/ countries. The first method, called absolute advantage, is the way most people understand technology differences. The second method, called comparative advantage, is a much more difficult concept.

His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people. A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries.

To better understand how modern global trade has evolved, it’s important to understand how countries traded with one another historically. Over time, economists have developed theories to explain the mechanisms of global trade. The main historical theories are called classical and are from the perspective of a country, or country-based.

In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully. But first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.

Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 20.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 20.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 33.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 33.4). The concept is often contrasted with comparative advantage, which was explored after Smith by economists like David Ricardo.