Absolute advantage International Trade, Comparative Advantage & Trade Theory

Money from sales to buy other goods – which are inefficient if produced domestically – from other countries. An example of how absolute cost advantage can be used in marketing is in the production of cars. Suppose a company has a better car than any other company in the market.

After trade, as it specialises in the production of X commodity, the total output of 40 units of X is turned out by A and it produces no unit of Y. After trade it specialises in Y and produces 40 units of Y and no unit of X. The gain from trade for country A is +20 units of X and -10 units of Y so that net gain to it from trade is +10 units of X. In fact, other factors, such as capital and natural resources, can also affect unit costs. For example, capital such as more technologically advanced machines allows us to produce output at a lower cost.

This implication makes a clear departure from the assumption held in the comparative cost approach that the resources are fully employed even before trade. If it is related to the factors of production – not only labor, as Adam Smith argued, it can come from several ways. For example, two countries, Indonesia and Malaysia, produce shoes and clothing.

A more detailed and satisfactory explanation concerning the basis of international trade has been provided by David Ricardo and J.S. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Visit this website for a list of articles and podcasts pertaining to international trade topics.

1. The gain in output can be distributed between the two countries through voluntary exchange.
2. Adam Smith assumes that we will get constant returns as production scales, meaning there are no economies of scale.
3. In “The Wealth of Nations”, Smith first points out that, through opportunity costs, regulations favoring one industry take away resources from another industry where they might have been more advantageously employed.
4. With trade, the United States can consume more of both goods than it did without specialization and trade.
5. 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.

Adam Smith assumes that we will get constant returns as production scales, meaning there are no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then absolute advantage theory it should take 4 hours to produce two loaves of bread. It does not explain the possibility of specialisation and international trade if one country has an absolute advantage in both goods.

Pros and Cons of Absolute Advantage

An individual, business, or country is said to have an absolute advantage if it can produce a good at a lower cost than another individual, business, or country. New Zealand has an absolute advantage in agriculture due to its favourable climate and abundant natural resources. As a result, it specialises in agriculture and exports agricultural products to other countries.

Barriers to Trade

It is important to note that absolute advantage looks into the efficiency of production for a single product. The theory assumes no transportation costs, which can have a significant impact on trade patterns. Point P2 (40, 0) shows output after specialisation before international trade. In order to do international trade, countries have to deciode the barter exchange rate. Let’s use a data example to better understand the concept of absolute advantage. The mercantilist economic theory, which was widely followed between the 16th and the 18th century, came under a lot of criticism with the emergence of economists like John Locke and David Hume.

Zambia and Copper Production

Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good. Table 20.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good. Absolute advantage refers to situations wherein one firm or nation can produce a given product of better quality, more quickly, and for higher profits than can another firm or nation.

An interesting aspect of Smith’s analysis of trade has been his ‘Vent for Surplus’ doctrine. According to him, the surplus of production in a country over what can be absorbed in the domestic market can be disposed of in the foreign markets. It was basically this desire that led Mercantilists and subsequent theorists to place much emphasis on the international trade. Given the techniques and factor endowments, if all the resources are employed in the production of X commodity, it can produce OA1 quantity of X.

Despite these differences, both Smith’s theory of absolute advantage and Ricardo’s theory of comparative advantage justify the benefits of specialisation and international trade. The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, https://1investing.in/ the United States can produce 50 barrels of oil or 100 bushels of corn. 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.

Reasoning that all countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing countries to focus on agricultural exports, rather than industrialization. As a result, many of these countries remain at a low level of economic development. In modern trade, however, globalization has now made it easy for companies to move their factories abroad. It has also increased the rate of immigration, which impacts a country’s available workforce. In some industries, businesses will work with governments to create immigration opportunities for workers that are essential to their business operations. In these models, workers and businesses do not relocate in search of better opportunities.

The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can be produced with fewer resources in one country over another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains.

The United States produces/consumes 20 barrels of oil and 60 bushels of corn. 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. With trade, the United States can consume more of both goods than it did without specialization and trade.

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. In economics, absolute advantage refers to the capacity of any economic agent, either an individual or a group, to produce a larger quantity of a product than its competitors. If each country were to specialize in their absolute advantage, Atlantica could make 12 tubs of butter and no bacon in a year, while Pacifica makes no butter and 12 slabs of bacon. By specializing, the two countries divide the tasks of their labor between them. More crucially, these theories both assume that a country’s absolute advantage is constant and scales equally.

The Theory of Absolute Advantage

Many times authors write “comparative advantage” when in actuality they are describing absolute advantage. This misconception often leads to erroneous implications, such as a fear that technology advances in other countries will cause our country to lose its comparative advantage in everything. The Blue country has an Absolute Advantage in the production of Good A (2 hours).

He explains that it is better to import goods from abroad where they can be manufactured more efficiently because it allows the importing country to put its resources into its own most productive and efficient industries. Smith thus emphasizes that a difference in technology between nations is the primary determinant of international trade flows around the globe. Resource-poor countries can focus on products with lower opportunity costs than other countries. David Ricardo criticized the absolute advantage introduced by Adam Smith. He then introduced comparative advantage, which places opportunity costs as the primary consideration in production decisions, not absolute costs, as Adam Smith put it.

In the above case, the price of clothing in Malaysia is lower than in Indonesia because it bears lower opportunity costs than in Indonesia. Likewise, Indonesia produces more affordable shoes because it has a lower opportunity cost than Malaysia. For example, Indonesia can make 1 shoe at an opportunity cost of 0.5 clothes (3/6).