ABSOLUTE ADVANTAGE THEORY

INTERNATIONAL TRADE THEORY

INTENATIONAL TRADE International trade is the exchange of capital, goods, and services across international borders or territories. international trade has existed throughout history (for example Uttarapatha, Silk Road, Amber Road, salt roads), its economic, social, and political importance has been on the rise in recent centuries.

INTERNATIONAL TRADE THEORIES To understand the pattern in international trade, Different trade theories are postulated. Some famous trade theories are:1. Mercantilism2.Absolute Advantage Theory3. Comparative Advantage Theory4. Hecksher-Ohlin Factor endowment theory5. Product Life Cycle Theory6. New Trade Theory7. Porter’s Diamond Theory for competitive advantage

ABSOLUTE ADVANTAGE THEORY: ORIGIN

The trade theory that first indicated importance of specialization in production and division of labor is based on the idea of theory of absolute advantage which is developed first by Adam Smith in his famous book The Wealth of Nations published in 1776. Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage. Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.

DRAWBACKS OF MERCANTILISM THEORY OR NEO-MERCANTILISM THEORY1. Mercantilism weakens a country2. Restrictions on free trade decreases country’s

wealth 3. Overlooks other factors such as natural resources,

manpower and its skill level, capital etc.4. Restrictive Policies promoting exports and restrict

imports creating trade barriers5. Colonial Exploitation

ABSOLUTE ADVANTAGE THEORY : ASSUMPTIONS1. Trade is between two countries

2. Only two commodities are traded

3. Free Trade exists between the countries

4. The only element of cost of production is labour

ABSOLUTE ADVANTAGE THEORYAdam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country producing it.

Countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

In economics, principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources.

ABSOLUTE ADVANTAGE THEORY : SIMPLE TERMS1. Theory is based upon principle of division of labour.

2. Free Trade among countries can increase a country’s wealth

3. Free Trade enables a country to provide a variety of goods and services to its people by specializing in the production of some goods and services and importing others.

4. Every country should specialize in producing those products at cost less than that of other countries and exchange these products with other products produced cheaply by others.

5. When one country produces a product at a lower cost and another country produces another product alt lower cost, both can exchange required quantity and can enjoy benefits of absolute cost advantage.

GAINS OF TRADENUMERICAL EXAMPLE

& GRAPHICAL PRESENTATION

ABSOLUTE ADVANTAGE THEORY

PPF – Production Possibility Frontier

The slope of the curve reflects the ‘trade-off’ of producing one product over the other, representing opportunity cost.

ADVANTAGES, SIGNIFICANCE &

LIMITATIONS ABSOLUTE ADVANTAGE THEORY

ABSOLUTE ADVANTAGE THEORY: ADVANTAGES ABSOLUTE COST ADVANTAGE1.Specialization : Specialization of labour leads to higher

productivity and allows to achieve less labour cost per unit of output.

2.Suitablity : Suitability of the skills of labour of the country in producing certain products

3.Economies of : Economies of Scale helps to reduce Scale the labour cost per unit of output

NATURAL ADVANTAGE

1.Natural Resources

2.Climatic Conditions

Example:A.India - Production of Rice, wheat, sweet mangoes, grapes, Tea, Coconuts,

Cashew nuts, cotton, etc.B.Sri Lanka - Production of Tea & RubberC.USA - Production of wheat

AQUIRED ADVANTAGE

1.Technology

2.Skills

Example : Japan - Advantages in steel production through

imports of steel & coalEngland - Production of TextilesFrance - Production of Wine

ABSOLUTE ADVANTAGE THEORY: SIGNIFICANCE1. More quantity of both products2. Increased standard of living for both

countries3. Increased production efficiency4. Increase in global efficiency and

effectiveness5. Maximization of global productivity and

other resources productivity

ABSOLUTE ADVANTAGE THEORY: LIMITATIONS1. No absolute advantages for many countries

2. Country size varries

3. Country by country differences in specializations

4. Deals with labour only and neglects other factors of production

5. Neglected Transport cost6. Theory is based on an assumption that Exchange rates are

stable and fixed.7. It also assumes that labor can switch between products easily

and they will work with same efficiency which in reality cannot happen.