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Absolute Cost Advantage Theory March 25, 2010

Posted by Chetan Chitre in International Business Management, International Trade Theory.
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Why does trade take place between two countries? What are the advantages and disadvantages of International Trade to different countries? What factors determine whether trade would be beneficial or detrimental to the interests of a country? These are some of the questions that are addressed by International Trade Theories.

The approach towards understanding these issues is theoretical – which means that instead of focusing on specific instances, the theory attempts to draw generalizations as regards the solutions or explanations that it offers.

History and Background –

International Trade is as old a human civilization and attempts have been made to give theoretical explanations for trade in the early works such as Kautilya’s Arthashastra.

However, modern theory of International Trade begins from the advent of Mercantilism in Europe (c. 1500 – 1750)

Mercantilism –

Till c. 1500 most of the trade happening around the world was demand driven. Not all commodities demanded by people were produced locally. Hence, merchants travelled in search of these commodities to meet the demand. This was the essential driver for trade.

The European renaissance and the subsequent industrial revolution for the first time in the history of the world led to generation of a “production surplus”. And therefore one of the main objectives of trade subsequently was to sell surplus production. Thus Trade shifted from being demand driven to supply driven.

The industrial revolution in Europe gave rise to an influential merchant class that survived on trade opportunities which arose due to – (i) need for huge supply of raw materials for factories and (ii) sale of surplus finished goods produced by factories.

While trade flourished, the Governments of the day thought there was valid reason to put restrictions of free trade. This was for the following reason –

# Governments thought that bullion was the key source of a Nation’s wealth. Being wealthy therefore meant accumulating larger and larger amounts of gold.

# Most countries were on Gold standard which meant that the currencies of the countries were convertible into gold – when exchanged with the country’s government.

# All exports meant inflow of money – and as all money was convertible into gold – it meant inflow of gold – and therefore resulted in increase in a Nation’s wealth

# Similarly all imports led to outflow of gold and hence reduction in a nation’s wealth.

Government therefore thought that in order to increase the wealth of nations it was important to encourage exports and discourage imports. This was the Mercantilist thought on International Trade.

Criticisms – It was pointed out that with the above logic, a nation will never be able to perpetually increase its wealth -

# An increase in exports would lead to inflow of gold. In a Gold standard this would lead to an increase in money supply. An increase in Money supply would lead to inflation.

# Due to inflation exports would become costlier and hence non- competitive. On the other hand people would prefer imported goods as they would be cheaper compared to domestic goods.

# This would lead to fall in exports and rise in imports and thus an outflow of Gold – thereby reversing the cycle.

# Critics therefore pointed out that y the mercantilist logic the country would keep oscillating between being a bullion surplus and a bullion deficit country.

This is not observed in real life. Therefore a revision was necessary in the understanding of International Trade.

Absolute Cost Advantage Theory –

With the apparent failure of the Mercantilist Theory to explain International Trade, search began for alternative explanations. Another reason for an alternative explanation was also the fact that using the Mercantilist theories, governments of the day imposed several restrictions on the activities of the merchants.

The utilitarian atmosphere of the times on the other hand advocated freedom of choice to individuals in all walks of life including economic and trade related matters. It questioned and advocated for removal of all sorts of restrictions on human behavior placed either by State or by religion.

Adam Smith’s Absolute Advantage Theory was therefore an answer to these issues.

According to this theory Trade between Nations took place if the traders saw an absolute advantage cost advantage in buying a particular good from a foreign country rather than buying the same good domestically.

This can be illustrated through the following example –

Bread Cloth
India 100 50
England 50 100

The above table shows units of labor required to produce Cloth and Bread in 2 countries – India and England.

India can produce bread with 100 units of labor while England can produce the same quantity of bread with 50 units of labor. Clearly England can produce bread in a more efficient manner than India. India would therefore import bread from England.

Further assuming that both countries have the same currency (say $) and same wage rates (say 1 $ per unit of labor) – It can be seen that the cost of production of bread in India would be 100$ while that of producing the same quantity of bread in England would be 50$. It would thus be advantageous for Indians to buy Bread from England at anything less than 100$. The Englishmen will also be happy to sell bread to Indians at anything more than 50$.

Thus we see that both countries stand to gain if India imports bread from England.

An exactly reverse logic can be applied to Cloth where it can be shown that India would end up exporting cloth to England.

The trade here takes place because India enjoys a clear and absolute advantage in producing Cloth (50 units of labor as against 100 unit required in England) and vice versa as regards production of Bread.

Assumptions of Absolute Cost Advantage Theory –

# 2 countries, 2 commodity model

# Labor as the only input

# Single currency assumed thereby eliminating effects of exchange rate changes

# Homogeneous factors of production – All labor units are of same type. They can be freely moved from production of cloth to production of bread and vice versa. i.e. No specialized labor.

# Units of production are divisible in compact units.

# All factors of production are fully employed.

# No government restrictions on free trade.

Criticisms of Absolute Advantage Theory –

Most of the criticisms from absolute advantage theory would arise because of the unrealistic nature of its assumptions.

However, an important incompleteness in the theory was the fact that it addressed only a situation wherein one country enjoyed an absolute advantage in production of a commodity over another country. It was pointed out that such situations are rare. Quite often the advantage is not an absolute advantage but a comparative one as would be clear from the Ricardian Theory of Comparative Cost Advantage.

Absolute Cost Advantage Theory – Simplified Version

Another way of looking at Adam Smith’s Absolute Cost Advantage Theory can be as follows –

# Efficiency of production in each country is different depending on several factors such as geographical, availability of natural resources, quality of raw material available, etc.

# Under the assumption that the labor is the only input for production, this difference in efficiency is reflected in the difference in productivity of labor.

# Assume that the productivity of 1 unit of labor in England and India is given by the following table

Bread Cloth
India 5 10
England 10 5

# 1 unit of labor in India produces 5 units of Bread or 10 units of cloth. Thus India is efficient in producing Cloth. Similarly 1 unit of labor produces 10 units of bread or 5 units of cloth. Clearly England has advantage in production of Bread.

# Given this condition it is clear that England will specialize in production of Bread and India will specialize in production of cloth.

# In this method it is also possible to derive the advantages of trade in a simple way –

# Assuming as in the above table each country is endowed with 2 units of labor.

# In India 1 unit of labor produces 5 units of bread and the other unit produces 10 units of cloth.

# If India decides to specialize in production of cloth, it would shift its 1 unit of labor producing bread and ask the worker to produce cloth.

# Now India produces 0 (zero) bread and 20 units of cloth. It will end up importing bread from England.

# Applying the same logic to England, will tell us that England will now specialize in production of bread and produce 20 units of bread and no cloth. England will import cloth from India.

# It is interesting to note here the effect on total production. Before trade as given in the above table, the world production of Bread was 15 units (10 in England + 5 in India) and the world production of cloth was 15 units (5 in England + 10 in India). Post trade the world production of Bread is 20 units (0 in India + 20 in England) and that of cloth is 20 units (20 in India + 0 in England)

# Thus the additional 5 units of bread and 5 units of cloth produced would be the net gain from International Trade.

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Comments»

1. Mrugnayan - April 24, 2012

Nice explanation…..

2. prateek - January 21, 2012

Appreciate the form in which theory has been put up and explained!!!


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