world of economics
Absolute Advantage Theory
- Adam Smith said that trade between two nations is based on absolute advantage.
- When one nation is more efficient than another in the production of one commodity but is less efficient than the other nation in producing a second commodity, then both nations can gain by each specializing in the production of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.
- By this process, resources are utilized in the most efficient way and the output of both commodities will rise. This increase in the output of both commodities measures the gains from specialization in production available to be divided between the two nations through trade.
Example of Absolute Advantage
- Suppose, there are two countries, A and B. Here, A is better at producing tea and B is better at producing Coffee. Also, due to the efficiency of Country A in producing tea, it takes less time to produce tea than Country B. And the same happens with Country B in the case of Coffee.
- Now, rather take higher time in producing Coffee, Country A will prefer to import it and likewise, Country B will find it profitable to import tea rather than producing it at a higher time and cost in their own country.
- In this case, Country A will end up importing coffee and exporting tea. And Country B will end up importing tea and exporting Coffee. This is what the absolute cost theory is trying to say.
Assumptions of the Theory
- 2X2 model and 1 factor of Production (2 Country and 2 commodities)
- Factors of production are under perfect competition
- Constant returns to scale
- Country A has absolute advantage in one commodity and absolute disadvantage in other commodity.
- No government interference
- Full employment in the economy
- BOP account is in equilibrium
- Schedule shows that there are 2 countries United States (US) and United Kingdom (UK) and both are producing Wheat and Cloth.
- It shows that one hour of labour time produces 6 bushels of Wheat is U.S but only one bushels of wheat in U.K.
- On the other side, One hour of labour time produces 5 Yards of cloth in U.K, but only 4 yards of cloth in U.S.
- Thus, the U.S is more efficient than, or has an absolute advantage over the UK in production of wheat, whereas the UK is more efficient than or has an absolute advantage over the United States (U.S) in the production of cloth.
- With trade, the US would specialize in the production of wheat and exchange of it for British cloth. The opposite is true for the United Kingdom (U.K).
- If US exchange 6 bushels of wheat (6w) for 6 yards of British cloth (6c), the US gain 2 cloths (2 C) or save 30 minutes of labour time (since the US can only exchange 6w for 4c domestically).
- Similarly, the 6W that the UK receives from the US is equivalent to or would require 6 hours of labour time to produce in UK. These same 6 hours can produce 30 cloths in the UK (6 hours times 5 yards of almost 5 labour hours.)
- The fact that the UK gains much more than the US is not important at this time.
- The important thing is that, both nations can gain form specialization in production and trade.
Criticism of Absolute Advantage Theory
- Adam Smith’s theory could not explain why the trade takes place even when one of the trading countries does not have absolute cost advantage in both the commodities compared to the other country.
- Absolute cost advantage theory can explain only a very small part of world trade such as trade between tropical zone and temperate zone or between developed countries and developing countries.
- Most of the world trade is between developed countries that are similar with respect to their resources and development which is not explained by absolute cost advantage.
- So another theory by David Ricardo, who gave the principle of comparative cost advantage as the basis for trade.