Her productivity and income will be highest if she specializes in the higher-paid legal services and hires the most qualified administrative assistant, who can type fast, although a little slower than Miranda. By having both Miranda and her assistant concentrate on their respective tasks, their overall productivity as a team is higher. A person or a country will specialize in doing what they do relatively better. In reality, the world economy is more complex and consists of more than two countries and products.
The theory of absolute advantage represents Adam Smith’s explanation of why countries benefit from trade, by exporting goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple illustration of the benefits of trade, it did not fully explain the benefits of international trade. That would later fall to David Ricardo’s theory of comparative advantages.
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 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of Nations. Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good.
- In this example, there is symmetry between absolute and comparative advantage.
- Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2.
- It is possible for an economy to have an absolute advantage in everything.
- Most of the backward countries with inefficient labour and machinery may not be enjoying absolute advantage in any line of activity.
And global trade allows countries to obtain goods cheaper from abroad than to produce them at high costs domestically. According to this theory, each country should specialize in producing certain goods with an absolute advantage. They then sell the goods to other countries other than to meet domestic demand. Money from sales to buy other goods – which are inefficient if produced domestically – from other countries.
Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Nearly every country, at one point or another, has implemented some form of protectionist policy to guard key industries in its economy. While export-oriented companies usually support protectionist policies that favor their industries or firms, other companies and consumers are hurt by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services.
What Are the Different International Trade Theories?
Barriers to trade may exist, and goods must be transported, stored, and distributed. However, this simplistic example demonstrates the basis of the comparative advantage theory. In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of Nations (Smith, 1776). Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation.
Problem with the Theory of Absolute Advantage
Other combinations of both oil and corn are possible, such as point C’. All points above the frontiers are impossible to produce given the current level of resources absolute advantage theory and technology. Specialization, division of labor, and trade with producers who have different absolute advantages leads to more gains than production in isolation.
Principles of Economics: Scarcity and Social Provisioning (2nd Ed.)
While at the surface, this many sound very simple, there is a great deal of theory, policy, and business strategy that constitutes international trade. Suppose to specialize in the production of Wheat, the U.S.A. withdraws 6 man-hours from the production of cloth and devote them to the production of wheat, it will lose 1 unit of cloth and gain 2 units of wheat. Since in the Ricardian model the PPF is linear, the opportunity cost is the same at all possible production points along the PPF.
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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, the United States can produce 50 barrels of oil or 100 bushels of corn.
Hence these countries have become the optimal locations for labor-intensive industries like textiles and garments. For instance, some countries still apply for trade protection through tariffs and quotas. In addition, non-tariff barriers such as consumption and environmental safety requirements still exist. For example, greater public infrastructure investment can reduce transportation costs. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.
Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume or quality. 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. 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. Every country tends to specialize in the production of that commodity which it can produce most cheaply.
Assumptions of the Absolute Advantage Theory
So, if China has to choose between producing computers over smartphones, it will probably select computers because the chance of profit is higher. The opportunity cost of a given option is equal to the forfeited benefits that could have been achieved by choosing an available alternative in comparison. In general, when the profit from two products is identified, analysts would calculate the opportunity cost of choosing one option over the other. In this case, the perspective lies in the fact that a country or business has the resources to produce a variety of goods and services rather than focus on just one product. 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.
Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 33.3). When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant.
The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries.
It turns out that Miranda can also type faster than the administrative assistants in her office, who are paid $40 per hour. Even though Miranda clearly has the absolute https://1investing.in/ advantage in both skill sets, should she do both jobs? For every hour Miranda decides to type instead of do legal work, she would be giving up $460 in income.