The problem with this concept is that the possible gains of trade between two countries are not mutually beneficial. The country with absolute cost advantage gains, with little or no gains for the other. However, when it comes to trade, absolute advantage is not as important as comparative advantage. Comparative advantage takes into account the opportunity cost of specializing in one activity over another. In this example, there is symmetry between absolute and comparative advantage.
International trade arises because not every country produces all goods and services at the most efficient level. Moreover, some countries can deliver goods more efficiently than others. As a result, they make at a lower absolute cost per unit than other countries. Absolute advantage refers to the ability of an individual, group, or nation to produce a product or service more cheaply than another. This might be a result of inputs, such as natural resources, or because of the cost or productivity levels of labor.
- So far, the discussion has been strictly regarding trade and industrial advantage.
- On the other hand, Portugal commits 90 hours to produce one unit of wine, which is fewer than the UK’s hours of work necessary to produce one unit of wine.
- Smith was the first economist to bring up the concept of absolute advantage, and his arguments regarding the same supported his theories for a laissez-faire state.
Given the information in Table 20.1, this choice implies that it produces/consumes 60 barrels of oil. To be at point C’, the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn. A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. Adam Smith’s absolute advantage theory is based on the idea of productivity of labor when comparing two nations.
That would later fall to David Ricardo’s theory of comparative advantages. However, the producer and its trading partners might still be able to realize gains from trade if they can specialize based on their respective comparative advantages instead. Adam Smith also emphasised that specialisation on the basis of absolute cost advantage would lead to maximisation of world production.
Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 20.3). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil https://1investing.in/ for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade. Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn.
Case 1: Self-Sufficiency Output
All points above the frontiers are impossible to produce given the current level of resources and technology. Both absolute advantage and comparative advantage are enormously significant concepts for understanding how international trade works. According to Figure 1, the UK commits 80 hours of labor to produce one unit of cloth, which is fewer than Portugal’s hours of work necessary to produce one unit of cloth.
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.
Gains from Trade
Alternatively, if all the resources are used in the production of Y, it is possible to produce OB quantity of Y. The slope of production possibility curve is measured by the ratio of labour productivity in X to labour productivity in Y in each country. From the table above, Indonesia has an absolute advantage in producing clothing and shoes.
Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology. To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 20.2). Figure 20.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. 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 Absolute Advantage Theory also assumed that free trade exists between nations. It did not take into account the protectionist measures that are adopted by countries. The protectionist measures included quantitative restrictions, technical barriers to trade, and restrictions on trade on account of environmental protection or public policy. The ability to produce more of a good or service while using fewer resources compared to a competing entity. Other examples include Colombia and its climate—ideally suited to growing coffee—and Zambia, possessing some of the world’s richest copper mines. For Saudi Arabia to try and grow coffee and Colombia to drill for oil would be an extremely costly and, likely, unproductive undertaking.
Country A can produce more quantity of chairs; hence, country A has an absolute advantage in the production of chairs. Then, In country A, 10 workers can produce 40 chairs or 20 tables and each worker can produce 4 chairs or 2 tables. While in country B, 10 workers can produce 20 chairs or 40 tables and each worker can produce 2 chairs or 4 tables. A country has an absolute advantage in the production of that good, which it can produce in greater quantity with the same quantity of resources than another country. After specialisation, we assume countries are able to concentrate on doubling production because they produce only one good rather than two. If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each.
Disadvantages of absolute cost advantage theory
At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Absolute Advantage looks into the efficiency of production for a single product. This leads to a greater production of goods overall, as shown in the chart below. Mexico would produce 8,000 shoes, and 10,000 refrigerators, shown in the chart below.
In fact, several countries can produce the same product even though they do not have an absolute advantage, for instance, Japan, Germany, and the United States, in car production. In conclusion, the theory of absolute advantage provides a useful framework for understanding the benefits of international trade between countries. By specialising in the production of goods and services in which they have an absolute advantage, countries can increase their productivity and efficiency and reduce their production costs. Starting at point C, reduce Saudi Oil production by 20 and exchange it for 20 units of corn to reach point D (see Figure 2). Indeed both countries consume more of both goods after specialized production and trade occurs. A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good.
Suppose that both countries use half of their workers for the production of chairs and half for the production of tables. In country A, 5 workers will produce 20 chairs, and 5 workers will produce 10 tables. While in country B, 5 workers will produce 10 chairs, and 5 workers will produce 20 tables. Both Smith’s theory of absolute advantage, and Ricardo’s theory of comparative advantage, rely on certain assumptions and simplifications in order to explain the benefits of trade.
In other words, it assumes that producing a small number of goods has the same per-unit cost as a larger number and that countries are unable to change their absolute advantages. Since slope of AA1 is less than the slope of BB1, it signifies that country A has absolute advantage theory absolute cost advantage in the production of X commodity, while country B has the absolute cost advantage in the production of Y commodity. In case of this country, if all resources are employed in the production of X commodity, OB1 quantity can be produced.
If a country or business has an absolute cost advantage over its competitors, it can charge more for its products and still make a profit. This allows companies to stay ahead of the competition and increase their market share. The theory of absolute advantage was put forward by Adam Smith who argued that different countries enjoyed absolute advantage in the production of some goods which formed the basis of trade between the countries. In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation.
They largely influence how and why nations and businesses devote resources to producing particular goods and services. Absolute advantage describes a scenario in which one entity can manufacture a product at a higher quality and a faster rate for a greater profit than another competing business or country can accomplish. Conversely, comparative advantage considers the opportunity costs involved when choosing to manufacture multiple types of goods with limited resources. Each country focuses on the products it can produce at the lowest unit cost compared to other countries. So, if a country does not have an absolute advantage, then Adam Smith’s argument is not necessarily valid.