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Absolute Advantage Theory Example

by Suleman
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The early thoughts of international trade viewed as classical thoughts of International Trade. It includes the absolute advantage theory and comparative advantage theory. Adam Smith presented absolute advantage theory in 1776. David Ricardo, in 1819, presented comparative advantage theory. These ideas developed in the great Brittan during the 18th and 19th centuries.

After reading this lesson, students would be able to: Learn the views of mercantilists explain the fundamentals of Absolute advantage theory presented by Adam Smith in 1776.

Absolute Advantage Theory Example

The Theory of Absolute Advantage

The theory was presented by Adam Smith in 1776. In the eighteenth century, the influence of trade spread throughout the world.Observing that impact, Smith said the trade limits proposed by traders would limit world production, consumption, and public welfare. Therefore, he advised promoting free trade among nations. He further said that trade should improve by specializing in products that have the absolute advantage of trading partners.

The Idea of Absolute Advantage Theory

The main idea of Smith’s absolute advantage theory was the international division of labor. It means a specialization in the production of only a few goods by nations will increase efficiency and output.

By observing the absolute cost differences among countries, Smith said that autarky level price differences would lead to international trade. He said that an increase in production by the division of labor in individual countries would increase the international division of labor and production. And also thereby surplus products could divide among countries through international trade.

The Productivity of the Inputs

The main factor determining the cost of production is the productivity of the inputs. Smith mentioned they base on natural and acquired (human-made) advantages.

The natural advantage refers to natural resources such as climate, land, soil, and locations, etc. Human-made resources refer to special abilities and human skills of nations.

Thus, Smith said that, given the natural or acquired advantages in producing goods, a country could produce the own product at a lower cost, becoming more competitive than the trading partner.

Assumptions of Absolute Advantage Theory

Smith’s concept based on the labor theory of value. It assumed that labor has the following qualities.

  1. Labour is the only factor of production. It is homogeneous (no quality difference)
  2. The cost or the price of goods depends on the amount of labor.

For example, as shown in the table below

USA could produce soya using less number of labor units than the UK. Therefore, the USA has the cost-efficiency in producing soya than the UK.

Smith’s trading principle is the principle of absolute advantage.

In a two-country, division of labor and specialization would gain to the nation when it has an absolute cost advantage in producing one commodity. Similarly, another country would also have a similar advantage when it has a cost advantage for another product.

Thus, for the world to benefit from the international division of labor, each country must have a good that has absolute cost advantage than his trading partner. Accordingly, the state will export the good which has an absolute advantage and will import the commodity which has absolute cost disadvantage.

The absolute advantage theory base on the following assumptions.

  1. There are only two countries and two goods.
  2. Agents and individuals exhibit rational behavior.
  3. In each nation, labor is the only input.
  4. No money illusion (consider only relative prices, not the nominal money values.
  5. Perfect competition prevails in all markets.
  6. Labour can move freely among industries but cannot move between countries.
  7. The level of technology is fixed for both nations. Though nations have different technologies, each nation utilizes a common production method.
  8. No barriers to trade.
  9. Export must pay for imports.
  10. Production exhibits constant returns between labor and output.
  11. Transportation costs are zero.

Absolute Advantage Theory Example

Smith’s idea of absolute advantage can show in the below table. According to two countries and two goods model, there are two countries.

For example

The USA and UK produce two goods, such as soya and textile. Thus the USA spend 3 hours making one unit of soya and 6 hours to make one unit of textile while the UK spends 12 and 4 hours to one unit of soya and textiles, respectively.

Determination of Absolute Advantage

Good

Hours to make 1 unit

USA

Hours to make 1 unit

UK

Soya

Textile

3

6

12

4

Accordingly, the USA has the absolute advantage in producing soya (3<12), and the UK has an absolute advantage for making textiles (4>6).

It reflects that the USA could specialize soya since its cost is relatively lower than in the UK. Similarly, the UK has the least cost advantage for specializing textiles. Hence both countries can get the benefits of trade by specializing in the least cost item.

If the USA declines its production of textiles by 1 unit and uses its six units of labor for soya production, it could produce two units of soya instead of making one unit of textiles.

Eventually, the world soya production could be increased by 1 unit by specializing in the USA’s only soya. Similarly, textile production could increase by two units if the UK specializes in textiles by reducing 1 unit of soya and using it for textiles (see table 2).

Table 2: Gains from Specialization

Country

In production of soya

In production of textile

USA

UK

World Production

+2

-1

1

-1

+3

2

market prices of respective products in two countries are determined as follows

WA= Wage

Ps = Price of Soya

Pt= price of textile

Ps=WA x Hours = WA x 3

Pt_WA x Hours = WA x 6

Hence, PS/PT in USA is = (WA x 3)/ (WA x 6) = 3/6 = 1/2

Similarly prices in UK is; Ps=WA x Hours=WA x 12, Pt = WA x 4

Hence PS/PT in UK = (WB x 12)/ (WB x 4) = 12/4 = 3

Accordingly, ½ units of soya require to buy one unit of textile in the USA while 3 units of textile require to buy one unit of soya in the UK. It implies that soya is chief in the USA and textile is less cost in the UK.

Once trade allows by two countries, consumers in country A will buy its textile from country B. And also consumers in country B will buy its soya from country A because the cost of producing textile is expensive in USA and similarly cost of soya is expensive in United kingdom.

Thus as a result of autarky price differences in the two countries the USA will specialize and export its cost-effective product of soya by reducing textile. Similarly, the UK will specialize and export textile by reducing its expensive product of soya.

Criticisms of Absolute Advantage Theory

However, the theory of absolute advantage was criticized due to the following limitations;

  1. Unrealistic assumptions such as the labour theory of value, perfect competition and fixed technology are not matched with real world.
  2. The theory was not answered for the situation of countries which have absolute advantage for more than one products

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