Theory of Absolute Advantage | Analysis

Introduction

In response to the mercantilism system which dominated economics thought in the 18 century, Adam Smith introduce and gives extension discussion of absolute advantage theory in international trade and illustrate what to do if countries do not stick to the rule and maxim of international trade in An Inquiry into the Nature and Causes of the Wealth of Nations. Adam Smith prove wrong the belief of international trade between country was zero sum game which means the gaining of a country from international trade was the loss of other country. In additional, the international trade was positive sum game which means countries will gain benefit from trades.

In the illustration of absolute advantage theory, Adam Smith illustrate that a country which have absolute advantage over other country if its production capacity in goods and services is greater when using same amount of resources or its produce a good using fewer resources (lower opportunity cost). Adam Smith also says that a country should produce goods where its production capacity is the most efficient and trade those goods where its production is not efficient. In additional, absolute advantage theory can also applies in the regions, cities and firms and tariffs and quotas should not restrict international trade.

Adam Smith says the labor is fixed and homogeneous within a country. In additional, he also considers the labor is the only factor of production (input) and technology and production cost is constant in absolute advantage theory. He also illustrate that transportation cost are zero and countries use barter trade system in trading.

In conclusion, Adam Smith absolute advantage theory replaces the mercantilist idea and questions the objective of national governments which applies mercantilist idea and acquires wealth through restrictive trade policies. In additional, absolute advantage theory also measure a country wealth through the living standard of its people.

Theoretical background and Issues

In absolute advantage theory, there are issue which is do all countries have an absolute advantage.

Adam Smith does not consider the question if every country has an absolute advantage in the production of some goods. From a theoretical point of view, it could be possible that a country has no absolute production advantages or might lose them over time. Adam Smith’s theory suggests that absolute advantages develop as a consequence of trade and trade might be the incentive ways that leads to the creation of absolute advantages. However, nowadays, international trade is widely spread and the countries do not start equally. Rather, some countries are less productive and poorer. They might have an absolute advantage in those goods which only they are able to produce because of natural environment or condition. But those goods constitute only a small fraction of all traded goods. Smith gives another possibility for less productive countries to have an absolute advantage. He states that poor countries might be able to compete in the agricultural sector with rich, more productive countries.

Smith’s reaches this conclusion by state that the division of labor does not equally increase in all sectors of production and that wage levels differ internationally.

Another issue in absolute advantage theory is how the trading between developed countries that have an equally high level of development using absolute advantage theory. Unlike the theory of comparative advantage, which is complemented by intra-industry trade theory, Adam Smith’s absolute advantage theory can also help to understand trade between developed countries. Firms in developed countries produce similar industrial products and compete over profits and market shares. Trade and success is determined by absolute production advantages which means that ‘art and skill’ (technology and education of the workers) play a significant role.

Since this competition exists domestically there is no reason why this kind of competition should not exist internationally; especially because Adam Smith’s theory does not have a basic difference between domestic and international trade. An additional gain is technology transfer or international learning. Developed countries benefit from it to a greater extent than underdeveloped countries since they are able to make use of technological developments. This can explain, for example, why the technological level of Europe and North America has converged in fifty year.

As a result, a rich country benefits more from trade with another rich country than from trade with an underdeveloped country.

Discussion: Adam Smith’s Absolute Advantage Theory

To illustrate the theory of absolute advantage, presume that there are two countries (China and Germany), producing just two products (rice and cars). Assume that products are tradable without workers and costs are not moving between the two countries, but moving between the two sectors within a country. All workers are equally productive and as the only input in a country. Production technology in China differs from that in Germany (see table below).

Suppose that to produce 1 unit of rice, Germany requires 3 units of labor meanwhile China requires only 2 units of labor. Similarly, to produce 1 car, Germany needs 6 units of labor while China needs 8 units of labor. As the result, China is more efficient in the rice production and Germany is more efficient in the cars production. Therefore, China has an absolute advantage in the rice production and Germany has an absolute advantage in the cars production. To illustrate that specialization of production, coupled with international trade flows according to the theory (absolute advantage), can be profitable. In our example, presume that China produces less 1 unit of car yet this save up 8 units of labor so, now the labors can be used to produce 8/2=4 units of rice (opportunity cost of car production in the China). China has now produced extra 4 units of rice although produced less 1 car. Suppose that China must import 1 car from Germany if China wants to consume the same amount of cars like before. Germany needs 6 units of labor to produce this car. Thus, rice production drops by 6/3=2 units of rice (opportunity costs of car production in Germany) as these laborers must bring in from the rice sector. Now note that the total production of rice has increased by 2 units (4 units more in China and 2 units less in Germany), while the total production of cars remain unchanged (1 car less in China and 1 car more in Germany).

In conclusion, these extra units of rice show the potential gains from specialization if China and Germany focused on the production of the product which they can produce most efficiently. Both countries can gain benefit from the theory, when they exchange 3 units of rice for 1 car.

Argument: Is theory of absolute advantage best describes international trade?

Absolute advantage refers to a country’s ability to produce a certain good more efficiently than another country and it has three main arguments. First, it argues that regulations favoring one industry draw away real resources from another industry where they might have been more advantageously employed. Second, it mentions the important of specialization in a society. When someone has some advantages in produce or provides a good or services, he or she needs to specialize in the production. Third, specialization needs to be practice in international commercial policy and nations. It is better when a country is allows to focus on production of goods that it has absolute advantages and then import goods that other countries have absolute advantage.

Theory of absolute advantage provides a clear and simple view on international trade and helps country decide what to produces, import and also export but it has some drawback since it fails to explain why free trade can be advantages when one country has absolute advantage in producing all the goods. How would a country without having any absolute advantage in producing any good, join and gain from free trade with other countries. How will this country pay for its imports because it will produce nothing that is cheaper to produce as compared with other countries? This theory ignored to explain how differences in climatic conditions and natural resource can contribute to comparative advantages. Some country has no absolute advantage in all good cause by limited resources and technology may excluded in international trade market and consequently, it will lead to conflict in allocate resources in that particular country and insufficient in production.

Theory of absolute advantage focuses on which country can product good by using lesser resources. If there is no trade between countries, then the prices of good will indicates by its resources cost in each country. The difference in prices with no trade will reach an equivalent price with each good being exported from the initially low-price country and imported by the initially high-price country. Smith’s approach does not indicate what would happen if the same country had absolute advantage in both products. The theory of comparative advantage introduces by David Ricardo has solve this problem as it do not considers cost in production but opportunity cost. A country will trade in the pattern that maximizes its advantage.

Next, absolute advantage fails to illustrate the real situation in international market because of some assumption. First, it does not take transportation costs involved in selling the product into account. For instance, if product is exchanging between China and German, the transportation cost may cause the price even higher than the original price without trade because of long distance. Besides, Adam Smith assumes that exchange rates are stable which the case is seldom and hence it is a limitation. Furthermore, it also assumes that labor can switch between products easily and they will work with same efficiency which in reality cannot happen.

In conclusion, we do not think that theory of absolute advantage by Adam Smith best describe international trade in today world. This is because it fails to explain the condition of country that does not have any absolute advantage. In addition, assumptions that not fit to reality like ignore transportation cost, use stable exchange rates and assume same efficiency between labors causes it is not accurate.

Recommendation

A country with absolute advantage can produce a good at lower marginal cost (fewer materials, cheaper materials, in less time etc.) This means that, the country should implement specialization in the production of such goods. Specialization of good can be made by Research and Development which leads to improvement of existing products or procedures. For example, to increase the Agricultural productivity Scientist such as Biologist and Chemists will need to develop technologies which may eventually lead to more production. For example, if a country has an absolute advantage on producing wheat, farmers of that country has to balance the environmental concerns to meet the need in a sustainable way. In overall, Research and Development helps the countries with absolute advantage to specialize and maximize the productivity. This benefits the country’s economics state.

Next, a country in absolute advantage should carry out trade. This is because a country can produce goods more than its need. Therefore they should trade the goods with other countries. The trade can be goods for goods or goods for money. When the country is carrying out goods for goods trade it can acquire goods which it can’t produce in its country and vice versa. On the other hand, goods for money trade allow the country to strengthen its economic state and grow further.

Conclusion

In a nutshell, absolute advantage creates many benefits for a country. However, there are certain limitations to this theory that a country will have to face. Firstly, it does not consider the transportation cost of moving the products from one country to the other. This is because, transportation cost are counted in final selling price of the product. As transportation cost is also a factor in production price sometimes trading can be a loss to a country. Next, the theory also assumes that exchange rates are stable which in reality it is seldom. In the current economic world exchange rates changes rapidly. This can cause major loss to some country if they trade in a wrong time. This is because exchange rates play a major role in trade market. The next limitations are, labors also cannot switch between products and they won’t be able to work with same efficiency. Some labors will only have a few working skills and training which cannot be used to produce variety of goods. So, even though absolute advantage gives many benefits to a country but it also have some negative sides which a country will have to encounter and tackle it effectively.